14: Learning and Adaptation as a Source of Market Failure

Author(s):

David Goldbaum, Economics Discipline Group, University of Technology Sydney, Sydney, Australia

Date of publication: August 2013

Working paper number: 14

Abstract:

In the developed model, without knowing the trading strategies of the other traders in a financial market, traders cannot derive a rational expectations equilibrium. In a dynamic setting, market participants employ learning and adaptation to develop trading strategies to accommodate for this information de ficiency. Model-consistent use of market-based information generally improves price performance. It can also produce episodes of extreme sudden mispricing despite model generated historical support for its use. Simulations examine the impact of information constraints and bounded rationality on general price efficiency and sudden market mispricing.

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