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Internal Rationality, Imperfect Market Knowledge and Asset Prices

Klaus Adam and Albert Marcet

CEP Discussion Papers from Centre for Economic Performance, LSE

Abstract: We present a decision theoretic framework in which agents are learning about market behavior and that provides microfoundations for models of adaptive learning. Agents are 'internally rational', i.e., maximize discounted expected utility under uncertainty given dynamically consistent subjective beliefs about the future, but agents may not be 'externally rational', i.e., may not know the true stochastic process for payoff relevant variables beyond their control. This includes future market outcomes and fundamentals. We apply this approach to a simple asset pricing model and show that the equilibrium stock price is then determined by investors' expectations of the price and dividend in the next period, rather than by expectations of the discounted sum of dividends. As a result, learning about price behavior affects market outcomes, while learning about the discounted sum of dividends is irrelevant for equilibrium prices. Stock prices equal the discounted sum of dividends only after making very strong assumptions about agents' market knowledge.

Keywords: learning; internal rationality; consumption based asset pricing (search for similar items in EconPapers)
JEL-codes: D83 D84 G12 G14 (search for similar items in EconPapers)
Date: 2011-08
New Economics Papers: this item is included in nep-cba, nep-dge, nep-evo, nep-mic and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (104)

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Journal Article: Internal rationality, imperfect market knowledge and asset prices (2011) Downloads
Working Paper: Internal rationality, imperfect market knowledge and asset prices (2011) Downloads
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