Follies subdued: Informational efficiency under adaptive expectations and confirmatory bias

We study the informational efficiency of a market with a single traded asset. The price initially differs from the fundamental value, about which the agents have noisy private information (which is, on average, correct). A fraction of traders revise their price expectations in each period. The price at which the asset is traded is public information. The agents’ expectations have an adaptive component and a social-interactions component with confirmatory bias. We show that, taken separately, each of the deviations from rationality worsens the informational efficiency of the market. However, when the two biases are combined, the degree of informational inefficiency of the market (measured as the deviation of the long-run market price from the fundamental value of the asset) can be non-monotonic both in the weight of the adaptive component and in the degree of confirmatory bias. For some ranges of parameters, two biases tend to mitigate each other’s effect, thus increasing informational efficiency.

► We study the informational efficiency of a market with a single traded asset. ► We introduce two biases in the expectation formation: an adaptive component and a social-interactions component with confirmatory bias. ► We show that each of the deviations from rationality, taken separately, worsens the information efficiency of the market. ► We show that when the two biases are combined, the degree of informational inefficiency can be non-monotonic in each bias. ► For some ranges of parameters, two biases tend to mitigate each other’s effect, thus increasing informational efficiency.