Financial Markets can be at Sub-Optimal Equilibria

Abstract

We use game theory and Santa Fe Artificial Stock Market, an agent-based model of an evolving stock market, to study the optimal frequency for traders to revise their market forecasting rules. We discover two things: There is a unique strategic Nash equilibrium in the game of choosing forecast revision rates, and this equilibrium is sub-optimal in the sense that traders' earnings are not maximized an the market is inefficient. This strategic equilibrium is due to an analogue of the prisoner's dilemma; the optimal global state is unstable because each trader has too much incentive to `defect' and use forecasting rules that pull the market into thesub-optimal equilibrium.