General Equilibrium Theory with Imperfect Information, Bounded Rationality, Incomplete Markets, and the Wisdom of Crowds

Abstract

I study general equilibrium theory with incomplete information. When agents are not fully informed, they can end up purchasing a bundle of goods that is far from optimal. General equilibrium theory falls short of providing a satisfactory explanation of the ability of real markets to deliver good outcomes under these circumstances. I introduce the wisdom of crowds as a corrective for suboptimal individual behaviour. The wisdom of crowds refers to the empirically observed ability of crowds to show collective intelligence even when their constituent individuals do not. I show that when crowds are wise, aggregate demand, aggregate production and prices all approach their ex-post Pareto efficient levels. In a neighbourhood of equilibrium, prices follow a martingale process, providing a general equilibrium derivation of the efficient market hypothesis. A spot market that opens after the resolution of uncertainty delivers an outcome that is ex-post Pareto efficient. This is achieved without any contingent commodities or securities, and agents who act `naively' and needn't have any ability to predict future prices.