Expectations and Learning from Prices

Résumé

We study mislearning from equilibrium prices, and contrast this with mislearning from exogenous fundamentals. We micro-found mislearning from prices with a psychologically founded theory of “Partial Equilibrium Thinking” (PET), where traders learn fundamental information from prices, but fail to realize others do so too. PET leads to over-reaction, and upward sloping demand curves, thus contributing to more inelastic markets. The degree of individual-level over-reaction, and the extent of inelasticity varies with the composition of traders, and with the informativeness of new information. More generally, unlike mislearning from fundamentals, mislearning from prices i) generates a two-way feedback between prices and beliefs that can provide an arbitrarily large amount of amplification, and ii) can rationalize both over-reaction and more inelastic markets. The two classes of biases are not mutually exclusive. Instead, they interact in very natural ways, and mislearning from prices can vastly amplify mislearning from fundamentals. (With Paul Fontanier)