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Financial Market Equilibrium with Bounded Awareness 1

Author

Listed:
  • Ani Guerdjikova

    (GAEL - Laboratoire d'Economie Appliquée de Grenoble - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement - UGA - Université Grenoble Alpes - Grenoble INP - Institut polytechnique de Grenoble - Grenoble Institute of Technology - UGA - Université Grenoble Alpes)

  • John Quiggin

    (UQ [All campuses : Brisbane, Dutton Park Gatton, Herston, St Lucia and other locations] - The University of Queensland)

Abstract
We consider an infinite-horizon economy with differential awareness in the form of coarsening. Agents with limited awareness are averse to unfavorable surprises. As a result their optimal trades are measurable w.r.t. their respective awareness partitions. We define an equilibrium with differential awareness and illustrate how the obtained equilibrium allocations observationally differ from those in economies with full awareness. In particular, economies with differential awareness can exhibit (i) lack of insurance against idiosyncratic risk; (ii) partial insurance against aggregate risk; (iii) biased state prices even when beliefs are correct and (iv) overpricing of assets which pay on events with low aggregate payoffs. We next adapt the results of Guerdjikova and Quiggin (2019) to show that agents with different levels of awareness can survive and influence prices in the limit. In this sense, the characteristics identified above would persist in the long-run. Moreover, differential awareness can lead to belief heterogeneity even in the limit. This is in contrast with the classical result of Blume and Easley (2006) stating that only agents with beliefs closest to the truth can survive. Finally, we examine the individual welfare implications of bounded awareness. If an increase in awareness comes at the cost of wrong beliefs over the larger state-space, bounded awareness can simultaneously increase individual welfare (with respect to the truth) and help avoid ruin. In this sense, heuristics which constrain agents to invest in "assets they understand" can be both ecologically rational in the sense of Gigerenzer (2007) and improve the stability of financial markets by allowing a larger set of agents to survive.

Suggested Citation

  • Ani Guerdjikova & John Quiggin, 2023. "Financial Market Equilibrium with Bounded Awareness 1," Working Papers hal-03962427, HAL.
    • Handle: RePEc:hal:wpaper:hal-03962427
    Note: View the original document on HAL open archive server: https://hal.science/hal-03962427
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    References listed on IDEAS

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    1. Blume, Lawrence E. & Cogley, Timothy & Easley, David A. & Sargent, Thomas J. & Tsyrennikov, Viktor, 2018. "A case for incomplete markets," Journal of Economic Theory, Elsevier, vol. 178(C), pages 191-221.
    2. Markus K. Brunnermeier & Alp Simsek & Wei Xiong, 2014. "A Welfare Criterion For Models With Distorted Beliefs," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 129(4), pages 1753-1797.
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    1. Financial market equilibrium with bounded awareness
      by John Quiggin in John Quiggin on 2020-09-28 08:53:32

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    Cited by:

    1. Madotto, Matteo & Severino, Federico, 2023. "Heterogeneous awareness in financial markets," Journal of Economic Behavior & Organization, Elsevier, vol. 216(C), pages 26-41.
    2. Auster, Sarah & Kettering, Jeremy & Kochov, Asen, 2024. "Sequential trading with coarse contingencies," Journal of Economic Theory, Elsevier, vol. 220(C).

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    More about this item

    Keywords

    Ambiguity; Ambiguity-aversion; Survival;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets

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