Abstract
We introduce a notion of behavioral competitive equilibrium (BCE), to study house-holds' inability to tailor their consumption to the state of the economy. Our notion is motivated by limited cognitive ability (in particular attention, memory, and complexity) and it maintains the complete market structure of competitive equilibrium. Compared to standard competitive equilibrium, our concept yields riskier allocations and more extreme prices (both for consumption and for assets). Thus, limited cognitive ability can produce market data that are usually attributed to heightened degree of risk aversion. We provide a tractable model that is suitable for general equilibrium analysis as well as asset pricing in dynamic environments.
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