Heterogeneous Expectations, Volatility and Welfare

This paper explores the extent to which the lack of rationality of economic agents has affected the economic fluctuations of the U.S. hog market. The dynamic model of this paper adopts the framework of conventional rational expectations models and nests heterogeneity in expectations in the framework. In particular, the model assumes two types of economic agents. One (rational agent) has rational expectations and the other (boundedly rational agent) has static expectations. A log-likelihood function is constructed based on the model and the fraction of boundedly rational agents is estimated by the function. Subsequently, simulation experiments are performed to investigate the extent to which the presence of boundedly rational economic agents has affected the volatility of the economic variables of the market. In particular, two sets of artificial data are generated by the model, one set with the estimated fraction of boundedly rational agents and the other with their zero fraction. Next, the standard deviations of the quantity and price variables are computed using the simulated data and then compared. The welfare quantified as consumer surplus minus production costs is measured and compared in the same way. Empirical test results indicate that the presence of boundedly rational economic agents has increased the price and quantity volatility by 14 and 25 percent respectively, in the U.S. hog market for the period from 1945 to 1990. However, welfare turns out to be rarely affected by their presence as far as rational economic agents dominate the market.