Heterogeneous Expectations, Market Dynamics, and Social Welfare

This paper explores the extent to which the lack of rationality of economic agents has affected the economic fluctuations and the social welfare of the U.S. hog market. A group of articles has ascribed the business cycles of the hog market, observed by economists as early as the last century, mainly to a lack of rationality (cobweb expectations) of economic agents. In contrast, others, assuming the full rationality of economic agents, have ascribed them to production lags and external shocks. These two streams of thought are reconciled in this paper by adopting the mechanics of conventional rational-expectations models and assuming heterogeneity in expectations. The dynamic model presented here assumes two types of economic agents. One (rational agent) has rational expectations and the other (boundedly rational agent) has cobweb expectations. The fraction of boundedly rational agents is estimated along with other deep parameters of the model using actual market data. Then, simulation experiments are performed to investigate how the presence of boundedly rational economic agents has affected the volatility of the economic variables and the social welfare of the market. In particular, several sets of artificial data are generated by the model using the estimated parameter values as the fraction of the boundedly rational agents changes from zero to one. Each set of artificial data is related to a certain fraction of boundedly rational agents. Then, the variances of the quantity and price variables are computed using actual and artificial data and compared. Empirical test results indicate that some fraction of economic agents in the U.S. hog market are boundedly rational. According to preliminary simulation experiments, the higher the fraction of boundedly rational agents is, the more volatile the economic variables are. The social welfare will be measured and compared in the same way.