Individual Rationality and Market Efficiency

The demonstration by Smith [1962] that prices and allocations quickly converge to the competitive equilibrium in the continuous double auction (CDA) was one of the first and remains one of the most important results in experimental economics. His initial experiment, subsequent market experiments, and models of price adjustment and exchange have added considerably to our knowledge of how markets reach equilibrium, and how they respond to disruptions. Perhaps the best known model of exchange in CDA market experiments is the random behavior in the zero-intelligence (ZI) model by Gode and Sunder [1993]. They conclude that even without trader rationality the CDA generates efficient allocations and convergence of transaction prices to the proximity of the theoretical equilibrium price, provided only that agents meet their budget constraints. We demonstrate that by any reasonable measure prices don t converge in their simulations. Their budget constraint requires that a buyer s currency never exceeds her value for the commodity, which is an unnatural restriction. Their conclusion that market efficiency results from the structure of the CDA independent of traders profit seeking behavior rests on their claim that the constraints that they impose are a part of the market institution, but this is not so. We show that they in effect impose individual rationality, which is an aspect of agents' behavior. Researchers on learning in markets have been misled by their interpretation of the ZI simulations, with deleterious effects on the debate on market adjustment processes.