From zero-intelligence to Bayesian learning: the effect of rationality on market efficiency

Daniele Giachini, Shabnam Mousavi and Matteo Ottaviani ()
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Daniele Giachini: Institute of Economics & Department L’EMbeDS, Scuola Superiore Sant’Anna
Shabnam Mousavi: Max Planck Institute for Human Development
Matteo Ottaviani: Scuola Normale Superiore

Journal of Economic Interaction and Coordination, 2025, vol. 20, issue 3, No 4, 659-676

Abstract: Abstract In this paper, we investigate the relationship between individual rationality and price informative efficiency studying a prediction market model where agents repeatedly bet on the occurrence of a binary event following their subjective beliefs. We define individual rationality in terms of the amount of past observations used to update beliefs. In this way, a wide spectrum of rationality levels emerges, ranging from zero-intelligence to Bayesian learning. We show that the relationship between individual rationality and price informative efficiency is nonlinear and U-shaped. We argue that the results emerge from the particular interaction of two evolutionary forces operating at different levels: the market selection mechanism that moves wealth toward more accurate agents and the individual learning process that moves posterior probabilities over models depending on observed realizations.

Keywords: Information efficiency; Updating beliefs; Structure of the market; Evolution of markets; Market selection (search for similar items in EconPapers)
JEL-codes: C60 D53 D81 D83 G11 G12 (search for similar items in EconPapers)
Date: 2025
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DOI: 10.1007/s11403-024-00424-0

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