CFDP 1319

If You're So Smart, Why Aren't You Rich?Belief Selection in Complete and Incomplete Markets

Author(s): 

Publication Date: August 2001

Pages: 38

Abstract: 

This paper provides an analysis of the asymptotic properties of consumption allocations in a stochastic general equilibrium model with heterogeneous consumers. In particular we investigate the market selection hypothesis, that markets favor traders with more accurate beliefs. We show that in any Pareto optimal allocation whether each consumer vanishes or survives is determined entirely by discount factors and beliefs. Since equilibrium allocations in economies with complete markets are Pareto optimal, our results characterize the limit behavior of these economies. We show that, all else equal, the market selects for consumers who use Bayesian learning with the truth in the support of their prior and selects among Bayesians according to the size of the their parameter space. Finally, we show that in economies with incomplete markets these conclusions may not hold. Payoff functions can matter for long run survival, and the market selection hypothesis fails.

Keywords: 

Market selection hypothesis, subjective beliefs, general equilibrium, incomplete markets, complete markets

JEL Classification Codes:  D46, D51, D52, D81