Traditional economic theory assumes that economic agents (individuals or firms) always act in a purely rational manner, that is, agents always have perfect knowledge of potential outcomes and always choose optimal strategies for satisfying their preferences. A large body of evidence contradicts these assumptions. So in general the world consists of a mixture of some rational and some irrational agents.
How can aggregate behavior be understood in this context? One way to think about the problem is to use the twin concepts of complementary and substitute strategies.
Strategies are substitutes when agents profit by doing the opposite of others' strategies. In this case, rational agents counteract or limit irrational strategies. With substitutes, evidence indicates that a minority of rational agents may generate aggregate outcomes predicted by the fully rational model. This type of market provides an opportunity for better-informed traders to profit from poorly-informed traders. An example is the case of prediction markets in which an asset is traded up until a precise time when the asset price is determined. For instance, orange juice futures prices, which are very sensitive to cold weather, have been found to predict freezes in Florida better than U.S. Weather Service forecasts.
Strategies are complements when agents profit by matching the strategies of others. In this case rational agents' strategies amplifies irrational strategies. In the case of the stock market, for instance, because there is no fixed future time when a firm's value is determined, well-informed traders cannot guarantee a profit even if they have perfect knowledge of the fundamental value of a firm.
Because of the large amount of volatility in the stock markets, even a well-informed, well-capitalized investor takes a substantial risk by betting against the 'momentum' of the market and can be forced into following the crowd, that is, trying to predict the strategies of others and get there first. As Keynes said, "Markets can stay irrational longer than you can stay liquid." Thus we have examples of large mispricings in the stock market including mutual funds whose underlying aggregate value does not match the fund's share price.
A well-known example of the difference in these two situations can be seen when a firm is put into 'play', that is, when it appears that the firm will be acquired. Rational traders suddenly have an opportunity to use their knowledge to make a profit and the share price often increases dramatically. Clearly the reason is not a sudden increase in the intrinsic value of the firm.
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