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Internal rationality, imperfect market knowledge and asset prices

Adam, K. and Marcet, Albert (2011) Internal rationality, imperfect market knowledge and asset prices. Journal of Economic Theory, 146 (3). pp. 1224-1252. ISSN 1095-7235

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Identification Number: 10.1016/j.jet.2010.11.003

Abstract

We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be 'externally rational', i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors' expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents' market knowledge.

Item Type: Article
Official URL: http://www.elsevier.com/wps/find/journaldescriptio...
Additional Information: © 2011 Elsevier Inc.
Subjects: H Social Sciences > HB Economic Theory
Sets: Departments > Economics
Date Deposited: 20 Jun 2011 08:59
Last Modified: 21 Jun 2011 09:25
URI: http://eprints.lse.ac.uk/id/eprint/36856

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