Introduction to PNAS special issue on evolutionary models of financial markets

Abstract

One of the longest debates in economics involves the existence of a rare Hominid “species” known as Homo economicus , the economic human. H. economicus is able to determine the optimal use of its resources to maximize its well-being as defined by the assumptions of neoclassical economics, leading to behavior that has come to be known as economic rationality. When interacting with other members of this species in market settings, such behavior leads to a magical outcome. The participants’ self-interested efforts to exploit their disparate pieces of information aggregates, distills, and compresses their information into a single number: the price. And because no piece of information is left unused or uninterpreted in the process of price discovery, this market is deemed “efficient.” Prices fully reflect all available information, as Eugene Fama concluded in his first articulation of the efficient markets hypothesis (1). Modern financial theory and practice are built on the foundation of H. economicus and efficient markets. However, booms, busts, and financial crises have created stress fractures in that foundation, implying that investors are not fully rational, that markets are not infallible, and that their failure can be catastrophic for the global financial system. Behavioral economists, on the other hand, view investors and markets as fundamentally irrational and inefficient. From their perspective, H. economicus is a case study in cryptozoology, as relevant to scientific discourse as Sasquatch and the Loch Ness monster. Nevertheless, it is an empirical fact that markets behave well most of the time, and when they do break down, it is often for understandable and predictable reasons. In recent years, the two sides of this debate have moved closer as more sophisticated models of investor behavior and macroeconomic dynamics have been developed to rationalize empirical anomalies, such as the equity risk premium, excess stock market … [↵][1]1To whom correspondence may be addressed. Email: slevin{at}princeton.edu. [1]: #xref-corresp-1-1