Market Selection

Leonid Kogan, Stephen A. Ross, Jiang Wang, and Mark M. Westereld

August 2011
Abstract
The hypothesis that nancial markets punish traders who make relatively
inaccurate forecasts and eventually eliminate the eect of their beliefs on prices
is of fundamental importance to the standard modeling paradigm in asset pric-
ing. We establish straightforward necessary and sucient conditions for agents
making inferior forecasts to survive and to aect prices in the long run in
a general setting with minimal restrictions on endowments, beliefs, or utility
functions. We describe a new mechanism for the distinction between survival
and price impact in a broad class of economies. Our results cover economies
with time-separable utility functions, including possibly state-dependent pref-
erences, such as external habit formation.
Keywords: Financial Markets, Heterogeneous Beliefs, Price Impact, Survival,
General Equilibrium.

Kogan and Ross are from the Sloan School of Management, MIT and NBER, Wang is from the
Sloan School of Management, MIT, NBER and CAFR, and Westereld is from the Marshall School
of Business, University of Southern California. Corresponding authors address: Leonid Kogan,
Sloan School of Management, MIT, 100 Main Street, E62-636 Cambridge, MA 02142. Kogan can
be reached at lkogan@mit.edu. Ross can be reached at sross@mit.edu. Wang can be reached at
wangj@mit.edu. Westereld can be reached at mwesterf@usc.edu.
1 Introduction
It has long been suggested that evolutionary forces work in nancial markets: agents
who are inferior at forecasting the future will either improve through learning or per-
ish as their wealth diminishes relative to those superior in forecasting (e.g. Friedman
(1953)). If such an evolutionary mechanism works eectively, then in the long run
only those agents with the best forecasts will survive the market selection process
and determine asset prices. This market selection hypothesis (MSH) is one of the
major arguments behind the assumption of rational expectations in neoclassical asset
pricing theory. After all, if agents with more accurate knowledge of fundamentals do
not determine the price behavior in the market, there is little reason to assume that
prices are driven by fundamentals and not by behavioral biases. More generally, it
would be comforting that markets select for those agents with more accurate fore-
casts, even if agents with less accurate forecasts are replenished over time (e.g. in
overlapping generations economies). We show that in frictionless, complete-market
exchange economies, both parts of the MSH that traders with inferior forecasts do
not survive and that extinction destroys their price impact are false in general. With
minimal restrictions on endowments, preferences, and beliefs, we develop necessary
and sucient conditions for the validity of the market selection hypothesis.
Despite the appeal and importance of the market selection hypothesis, its va-
lidity has remained ambiguous. Existing studies use specialized models, mostly for
tractability and convenience, making it dicult to understand the economic mecha-
nism behind the MSH and the scope of its validity. For instance, relying on partial
equilibrium analysis, De Long et al. (1991) argue that agents making inferior forecasts
can survive in wealth terms despite market forces exerted by agents with objective
beliefs. Using a general equilibrium setting, Sandroni (2000) and Blume and Easley
(2006) show that only agents with beliefs closest to the objective probabilities will sur-
vive and have price impact. But, their results are obtained in economies with bounded
aggregate endowment. Kogan et al. (2006) demonstrate in a general equilibrium set-
ting without intermediate consumption that if aggregate endowment is unbounded,
agents with incorrect beliefs can survive.
1
In this paper, we perform a comprehen-
sive analysis of the MSH and its pricing implications in a general complete-market
1
A signicant body of work exists examining pricing implications of heterogeneous beliefs in
specic parameterized models, including Dumas et al. (2009), Fedyk et al. (2010), Xiong and Yan
(2010), and Yan (2008).
1
setting with time-separable preferences (including state-dependent preferences, e.g.,
catching up with the Joneses), not limiting ourselves to commonly used parametric
specications.
Kogan et al. (2006) draw the distinction between the two parts of the MSH. They
show, in a stylized setting, that even when agents with inferior beliefs do not survive
in the long run, their impact on prices can persist. In other words, survival and
price impact are two distinct concepts. In particular, an agent with relatively low
consumption level can aect the prices of low-aggregate consumption states because
the change in prices relative to wealth spent on consumption in such states is of order
1
C
, where C denotes agents consumption. As a result, by distorting the prices of
primitive Arrow-Debeu claims over a set of states of diminishing probability, it is
possible for the agent to persistently distort valuations of non-primitive assets, like
stocks and bonds, while failing to survive in the long run. In addition to relying on
a particular set of non-primitive nancial assets for their denition of price impact,
Kogan et al. (2006) assume the absence of intermediate consumption, CRRA prefer-
ences, and IID endowment growth, leaving it unclear how their results apply in more
general settings.
In this paper, we demonstrate that the distinction between survival and price
impact is a pervasive phenomenon which arises in standard innite-horizon models
with intermediate consumption and exible specication of time-separable prefer-
ences. Our analysis oers a more general and robust intuition for the distinction
between price impact and survival. In particular, we show that long-run price impact
can occur at the level of the primitive Arrow-Debreu claims, and not only at the level
of certain non-primitive long-lived assets.
2
Moreover, we show that price impact in
general settings does not hinge on the distortion in agents consumption over a set of
states of diminishing probability (specically, the low-aggregate endowment states).
Instead, price impact of distorted beliefs has to do with the ability of an agent holding
such beliefs to provide non-trivial risk sharing to other agents in equilibrium despite
of failing to survive in the long run.
We examine the MSH in frictionless and complete-market economies because com-
mon arguments in favor of its validity rely on unrestricted competition, no limits to
arbitrage, etc. To isolate the impact of disagreement, we populate our economies with
competitive agents who only dier in their beliefs. We then analyze how survival and
2
We discuss these alternative notions of price impact in detail in Section 2.
2
price impact properties of the economy depend on the primitives, such as errors in
forecasts, endowment growth, and risk aversion.
We nd that if agents risk aversion declines suciently fast as a function of their
consumption level, or if the aggregate endowment is bounded, then agents with more
accurate forecasts eventually dominate the economy and determine price behavior.
Thus, the market selection hypothesis does hold in these bounded economies, and
the rates of extinction in both consumption and price impact are proportional to
the growth rate of accumulated forecast errors. Without the economic bounds, the
survival of agents with less accurate forecasts and their impact on state prices are
determined by the tradeo between agents risk aversion, the magnitude of their
forecast errors, and the aggregate endowment growth rate. In an economy with
decreasing absolute risk aversion (DARA) preferences, endowment growth reduces
agents absolute risk aversion. If forecast errors do not accumulate fast enough over
time, compared to the rate of decline of risk aversion, agents with less accurate
forecasts can maintain a nontrivial consumption share and aect prices.
Agents with heterogeneous beliefs trade with each other to share consumption
across states, but whether this disagreement leaves one of the agents with a vanish-
ing consumption share depends on the agents preferences. When two agents dis-
agree in their probability assessment of a particular state, the more optimistic agent
buys a disproportionate share of the state-contingent consumption. If two agents
have diverging beliefs, they end up with extreme disagreement asymptotically over
most states. Pareto optimality implies that the ratio of agents marginal utilities
in each state must be inversely proportional to the ratio of their belief densities,
and therefore, asymptotically, divergence in beliefs leads to divergence in marginal
utilities. Whether or not large dierences in marginal utilities correspond to large dif-
ferences in consumption depends on the sensitivity of marginal utility to consumption,
d ln(U

(C))/d ln(C) = CU

(C)/U

(C) = CA(C), where A(C) = U

(C)/U

(C) is
the absolute risk aversion coecient. If risk aversion of the two agents declines slowly
in their consumption level, their marginal utility dierences may not translate into
large consumption dierences. In fact, as we show below (in Proposition 5.5), the two
agents may consume equal consumption shares asymptotically despite their growing
disagreement.
In addition, the conditions for survival and price impact are dierent. In equilib-
rium, the level of belief dierences determines the relative consumption levels of the
agents (survival), while the stochastic discount factor is determined by time-variation
3
in the marginal utility of consumption. An agent with a diminishing consumption
share may maintain a persistent impact on state prices as long as his presence aects
the uctuations in the marginal utility of the dominant agent. In other words, a
disappearing agent may aect the stochastic discount factor as long as he provides
nontrivial risk-sharing opportunities for the dominant agent.
To ush out this intuition further, consider an exchange economy with two agents.
Let D
t
be the aggregate endowment, and let the agents have preferences given by
U(C
t
). Assume that belief dierences imply that the second agent consumes C
2,t
,
which is an asymptotically diminishing share of the aggregate endowment. Thus,
the second agent does not survive in the long run. The rst agent consumes C
1,t
=
D
t
C
2,t
. Next, compare the stochastic discount factor in this economy to the one
in an identical economy without the second agent, i.e., with C
1,t
= D
t
.
The volatility of the stochastic discount factor equals the volatility of growth of the
marginal utility of the rst agent. Assuming that all quantities are driven by Ito pro-
cesses. In the second economy, the instantaneous stochastic component of the stochas-
tic discount factor is, by Itos lemma, stoch{dU

(D
t
)/U

(D
t
)} = A(D
t
)stoch(dD
t
),
where A(D) = U

(D)/U

(D) is the coecient of absolute risk aversion. This com-

pares to A(C
1,t
)stoch(dC
1,t
) in the rst economy. Suppose that A(C
1,t
) A(D
t
).
Then, the instantaneous dierence between the stochastic discount factors in the two
economies is approximately A(D
t
)stoch(dC
2,t
). If the consumption level of the second
agent is suciently volatile so that he is engaged in nontrivial risk sharing with the
rst agent, the discount factors in the two economies are quite dierent. Whether
such dynamics is observed in equilibrium depends on the agents preferences, as well
as their beliefs and the aggregate endowment process.
Our results cover general state-dependent preferences, such as external habit for-
mation or catching-up-with-the-Joneses. Such models of preferences are emerging as
increasingly important in recent asset pricing research. State-dependent preferences
change the risk attitudes of the agents in the economy, but they do not change how
those risk attitudes aect survival or price impact. We are therefore able to apply
the necessary and sucient conditions for the validity of the MSH to models with
state-dependent preferences that are commonly used in the literature. This aspect of
our analysis is new to our knowledge, and provides a rst exploration of the market
selection hypothesis in the context of behavioral preferences.
The paper is organized as follows. Section 2 sets up the model and denes survival
and price impact. Section 3 presents several examples of how survival and price impact
4
results depend on the primitives of the economy. Sections 4 and 5 present our main
results on survival and price impact. Section 6 covers economies with state-dependent
preferences. Section 7 concludes. Proofs and derivations are in the Appendix.
2 The Model
We consider an innite-horizon exchange (endowment) economy. Time is indexed by
t, which takes values in t [0, ). Time can either be continuous or discrete. While
all of our general results can be stated either in discrete or continuous time, some of the
examples are simpler in continuous time. We will use integrals to denote aggregation
over time. When time is taken as discrete, time-integration will be interpreted as
summation. We further assume that there is a single, perishable consumption good,
which is also used as the numeraire.
Uncertainty and the Securities Market
The environment of the economy is described by a complete probability space (, F, P).
Each element denotes a state of the economy. The information structure of the
economy is given by a ltration on F, {F
t
}, with F
s
F
t
for s t. The probability
measure P is referred to as the objective probability measure. The endowment ow is
given by an adapted process D
t
. We assume that the aggregate endowment is strictly
positive: D
t
> 0, P a.s.
In addition to the objective probability measure P, we also consider other proba-
bility measures, referred to as subjective probability measures. Let A and B denote
such measures. We assume that A and B share zero-probability events with P when
restricted to any nite-time information set F
t
. Denote the Radon-Nikodym deriva-
tive of the probability measure A with respect to P by
A
t
. Then
E
A
t
[Z
s
] = E
P
t
_

A
s

A
t
Z
s
_
(1)
for any F
s
-measurable random variable Z
s
and s t, where E
t
[Z] denotes E[Z|F
t
]. In
addition,
A
0
1 The probability measure B has a similar Radon-Nikodym derivative

B
t
. The random variable
A
t
can be informally interpreted as the density of the
probability measure A with respect to the probability measure P conditional on the
time-t information set.
5
We use A and B to model heterogeneous beliefs. We dene the ratio of subjective
belief densities

t
=

B
t

A
t
. (2)
Since both
A
and
B
are nonnegative martingales, they converge almost surely as time
tends to innity (e.g., Shiryaev (1996, 7.4, Th. 1)), and therefore the process
t
also
converges. Our results are most relevant for models in which the limit of
t
is either
zero or innity, implying that the agents beliefs, described by subjective measures A
and B, are meaningfully dierent in the long run. To see that convergence to a nite
limit implies that beliefs are not meaningfully dierent in the long run, consider the
subset of the probability measure where
t
converges to a nite limit. Then, the ratio

A
t+T
/
A
t

B
t+T
/
B
t
, T > 0, converges to one, so the nite-period forecasts implied by the two
subjective measures converge asymptotically.
3
We examine the asymptotic condition
on subjective beliefs in more detail in Section 3.
We assume that there exists a complete set of Arrow-Debreu securities in the
economy, so that the securities market is complete.
Agents
There are two competitive agents in the economy. They have the same utility function,
but dier in their beliefs. The rst agent has A as his probability measure while the
second agent has B as his probability measure. We refer to the agent who uses A as
agent A and the agent who uses B as agent B. It is clear from the context when we
refer to an agent as opposed to a probability measure.
Until stated otherwise, we assume that the agents utility function is time-additive
and state-independent with the canonical form
_

0
e
t
u(C
t
)dt
where C
t
is an agents consumption at time t, is the time-discount coecient and
u() is the utility function. We consider more general forms of the utility function
in Section 6. The common utility function u() is assumed to be increasing, weakly-
concave, and twice continuously dierentiable. We assume that u() satises the
3
See Blume and Easley (2006) for further discussion.
6
standard Inada condition at zero:
lim
x0
u

(x) = . (3)
We use A(x) u

(x)/u

(x) and (x) xu

(x)/u

(x) = xA(x) to denote, re-

spectively, an agents absolute and relative risk aversion at the consumption level
x.
Let C
A,t
and C
B,t
denote consumption of the two agents. Each agent maximizes
his expected utility using his subjective beliefs. Agent is objective is
E
i
0
__

0
e
t
u(C
i,t
) dt
_
= E
P
0
__

0
e
t

i
t
u(C
i,t
) dt
_
, i {A, B}, (4)
where the equality follows from (1). This implies that the two agents are observation-
ally equivalent to the two agents with objective beliefs P but state-dependent utility
functions
A
t
u() and
B
t
u() respectively.
The two agents are collectively endowed with a ow of the consumption good.
Let the initial share of the total endowment for agent A and B be 1 and ,
respectively.
Equilibrium
Because the market is complete, if an equilibrium exists, it must be Pareto-optimal. In
such situations, consumption allocations can be determined by maximizing a weighted
sum of the utility functions of the two agents. The equilibrium is given at each time
t by
max (1)
A
t
u(C
A,t
) +
B
t
u(C
B,t
) (5)
C
A,t
, C
B,t
s.t. C
A,t
+ C
B,t
= D
t
where [0, 1].
Concavity of the utility function, together with the Inada condition, imply that
the equilibrium consumption allocations satisfy the rst-order condition
u

(C
A,t
)
u

(C
B,t
)
=
t
, (6)
7
where we denote /(1) by .
We dene w
t
=
C
B,t
Dt
as the share of the aggregate endowment consumed by agent
B. The rst-order condition for Pareto optimality (6) implies that w
t
satises
ln(
t
) = ln(u

((1 w
t
)D
t
)) + ln(u

(w
t
D
t
)) =
_
(1wt)Dt
wtDt
A(x) dx, (7)
since A(x) =
d
dx
ln(u

(x)). This equation relates belief dierences (

t
) to individual
risk aversion (A(x)) and the equilibrium consumption allocation (w
t
and D
t
), and
will be our primary analytical tool.
Denitions of Survival and Price Impact
Without loss of generality, we focus on the survival of agent B and that agents impact
on security prices in the long run. If one replaces
t
with
1
t
in our analysis, our
results instead describe the survival and price impact of agent A.
We rst dene formally the concepts of survival and price impact to be used in
this paper and examine their properties.
Denition 1 [Extinction and Survival] Agent B becomes extinct if
lim
t
C
B,t
D
t
= 0, Pa.s.
Agent B survives if he does not become extinct.
The above denition provides a weak condition for survival: an agent has to
consume a positive fraction of the endowment with a positive probability in order to
survive.
We opt for a relatively conservative denition of price impact, and dene it in
terms of distortions in the prices of primitive state-contingent claims (or the stochastic
discount factor). This choice is natural for a frictionless complete-market economy.
An alternative would be to dene price impact over a set of non-primitive long-lived
assets, in analogy with Kogan et al. (2006). The set of economies in which agent
Bs beliefs aect prices of some long-lived assets is larger than the set of economies
with persistent distortions in the state-price density. In fact, it is typically easy
to construct a particular long-lived asset that is persistently aected by the belief
distortions, posing a question of which long-lived assets are more or less economically
8
relevant, and therefore should or should not be considered when checking for price
impact.
4
Our denition avoids such questions, which are ill-posed in the context of
complete frictionless markets.
Let m
t
denote the equilibrium state-price density. Pareto optimality and the
individual optimality conditions imply that
m
t
= e
t

A
t
u

((1 w
t
)D
t
)
u

((1 w
0
)D
0
)
= e
t

B
t
u

(w
t
D
t
)
u

(w
0
D
0
)
. (8)
In general, m
t
depends on , the relative weight of the two agents in the economy.
Thus, we write m
t
= m
t
(). We denote by m

t
() the state-price density in the
economy in which both agents have beliefs described by the measure A and hence

t
= 1. We dene m

t
(0) to be the state-price density in an economy in which all
wealth is initially allocated to agent A. We identify the price impact exerted by
agent B by comparing m
t
to m

.
Denition 2 [Price Impact] Agent B has no price impact if there exists

0,
such that for any s > 0,
lim
t
m
t+s
()/m
t
()
m

t+s
(

)/m

t
(

)
= 1, Pa.s. (9)
Otherwise, he has price impact.
Our denition formalizes the notion that agent B has no price impact if the equi-
librium stochastic discount factor is asymptotically indistinguishable from the one in
a reference economy with the same preferences but with both agents using the beliefs
of agent A. We allow for the initial wealth distribution in the reference economy to
dier from that in the original economy. Our motivation for this is straightforward,
as we illustrate with the following argument.
Consider an economy with an equal initial wealth distribution between A and
B. Suppose that A maintains objective beliefs, while the beliefs of B are inaccurate.
4
See the appendix, Section A.16, for an example of a standard economy in which distorted beliefs
have no long-run impact on the Arrow-Debreu prices, and yet prices of some of the long-lived non-
primitive assets are aected by belief distortions. The reason for price impact on the non-primitive
state-contingent claim we consider in our example is that its payo is concentrated on a set of states
in which agent B has a nontrivial consumption share. This set of states has an asymptotically
vanishing probability but is relevant for the pricing of long-lived non-primitive state-contingent
claims.
9
Suppose further that the primitives of the model are such that agent B becomes
extinct asymptotically and therefore agent A dominates the economy in the long run.
Assume that the stochastic discount factor in this economy converges asymptotically
to the one in an economy in which only agent A is present. Intuitively, one would
like to conclude that, because the stochastic discount factor converges to that of an
economy without B, the latter has no long-run impact on prices. If we insisted that
the reference economy must be obtained from the original model by simply setting
beliefs of both agents to those of agent A, we would generally be forced to conclude
that agent B maintains long-run impact on prices. The reason is that, in general,
the stochastic discount factor in the model with homogeneous beliefs depends on
the initial wealth distribution between the two agents.
5
Thus, to reect our basic
intuition, the denition for price impact must allow the reference economy to start
with a wealth distribution dierent from that in the original model.
In contrast to the notion of long-run survival, equations (8) and (9) show that price
impact is determined by changes in consumption over nite time intervals relative
to a benchmark economy. In particular, we compare the stochastic discount factor
in the original economy, m
t+s
()/m
t
(), to the one in a reference economy where
both agents maintain the same beliefs, but, possibly, have a dierent initial wealth
distribution, m

t+s
()/m

t
(

).
The above denition may seem dicult to apply because condition (9) must be
veried for all values of

. However, for economies in which agent B does not survive

it is often sucient to verify the denition for

= 0. As a measure of the magnitude

of price impact, we use
PI(t, s;

= 0) ln
_
m
t+s
()/m
t
()
m

t+s
(0)/m

t
(0)
_
=
_
D
t+s
D
t+s
(1w
t+s
)
A(x) dx
_
Dt
Dt(1wt)
A(x) dx,
(10)
where the nal equality follows from
u

(D(1 w))
u

(D)
= exp
__
D
D(1w)
A(x) dx
_
. (11)
5
As shown in Rubinstein (1974), the stochastic discount factor does not depend on the initial
wealth distribution in the special case when the agents utility function exhibits hyperbolic absolute
risk aversion.
10
Price impact can be similarly dened for any

, and the case of

= 1 is often
sucient when B survives.
Discussion of the Assumptions
Our analysis focuses on a specic question: Do markets select for relatively accu-
rate forecasts? Thus, we abstract away from dierences in utility functions across
agents. Understanding the behavior of economies with heterogeneous preferences is
an important topic, but it is distinct from the market selection hypothesis, which
postulates an evolutionary rationale for long-run market rationality. Thus, we isolate
the eect of belief heterogeneity on long-run survival and price impact.
We consider the setting without constraints on trading to evaluate the economic
mechanism behind market selection. It is clear that market incompleteness and con-
straints may have a direct impact on the long-run dynamics of prices. As a stark
illustration, consider an economy in which none of the agents are allowed to transact
in nancial markets. In this case, survival does not depend on beliefs, and prices
are arbitrary. Similarly, in an economy with nontrivial labor income, liquidity con-
straints may guarantee that agents cannot lose their future labor income by making
poor trading decisions, and thus survive. More generally, specic forms of market
incompleteness may impede transactions among agents, thus reducing the long-run
advantage of agents with more accurate forecasts (e.g., Blume and Easley (2006)).
Our frictionless framework helps investigate the logic of the original argument for the
validity of the MSH, which is based on unrestricted competition among agents, and
we show under what assumptions the argument is or is not valid.
Our description of the long-run market dynamics is qualitative. We study the
general conditions under which prices eventually reect superior forecasts, and we
characterize how the rate of convergence of consumption and prices depends on the
economic primitives. Yan (2008) calibrates the empirically plausible speed of selec-
tion in a particular parameterized economy in which agents with CRRA preferences
disagree about the growth rate of the aggregate endowment, and argues that market
selection in such an economy is likely to be slow. In contrast, Fedyk et al. (2010)
show that market selection speed is drastically higher when agents disagree about
multiple sources of randomness than an analogous economies with a single source of
disagreement. Thus, the market selection mechanism may work very slowly or very
11
quickly, depending on the assumed economic primitives.
6
Our analysis makes it clear
how these primitives drive the selection mechanism, and under what circumstances
market selection is eventually successful.
In our analysis we allow for general utility functions and do not restrict our-
selves to CRRA preferences. In addition to helping us to understand the role of
preferences in the MSH, such a general setting also addresses the issue of market
selection in many models used in the asset pricing literature. For example, models
investigating the link between market dynamics and heterogenous beliefs/asymmetric
information, wealth accumulation under uncertainty, savings in the presence of taxes,
trading costs, and market liquidity often use preferences with constant absolute risk
aversion.
7
As we show below, such preferences have very dierent implications for
market selection compared to the utilities with constant, or, more generally, bounded
relative risk aversion. Without taking a stand on which utility specication is most
convenient or realistic in any particular setting, we instead cover a broad spectrum
of possible individual preferences. Importantly, our results apply to state-dependent
preferences. These increasingly common specications allow risk aversion to be a
stochastic function of consumption, departing from pure power utility.
Finally, we have assumed that both agents have the same time discount factor.
This allows us to isolate the eect of heterogeneous beliefs, but this assumption
can be relaxed without loss in tractability. With dierent time discount factors, we
would have that the Pareto optimal allocation is
u

(C
A,t
)
u

(C
B,t
)
= e
(
A

B
)t

t
instead of (6).
This is equivalent to replacing the belief process
t
in our setting with the process

t
= e
(
A

B
)t

t
.
6
As we show, the rate at which
t
converges to zero is critical in determining the survival and
price impact of agents with relatively inaccurate forecasts. So, for example, if there is a constant
disagreement of over the drift of N dierent independent Brownian Motions Z
i
t
there are N
sources of disagreement then ln(
t
) =
1
2
N
2
t +

N
i=1
Z
i
t
. Thus, the selection speed in this
example is proportional to the number of sources of disagreement.
7
See for example Shefrin (2005) on heterogeneous beliefs; Caballero (1991) on aggregate wealth
accumulation; Kimball and Mankiw (1989) on savings; Vayanos (1999) and Lo et al. (2004) on
volume and microstructure; Gromb and Vayanos (2002), Huang and Wang (2009), Yuan (2005) on
liquidity and crashes; Garleanu (2009) on search.
12
3 Examples
In this section we use a series of examples to illustrate how survival and price impact
properties depend on the interplay of the model primitives and to provide basic in-
tuition for the more general results in the next section. Our examples are organized
in three sets. Each set compares economies diering from each other with respect to
only one of the primitives: endowments, beliefs, or preferences. Formal derivations
are presented in the Appendix.
3.1 Endowments
The following two examples illustrate the dependence of survival and price impact
results on the endowment process. We show that a change in the properties of the
economic environment (the endowment), holding the agents characteristics (beliefs
and preferences) xed, may aect the validity of the MSH, altering both the survival
and price impact results. In addition, we demonstrate an example in which survival
and price impact are not equivalent.
Our rst example has no aggregate uncertainty: investors dier in their beliefs
only over an extraneous source of randomness:
Example 3.1 Consider a continuous-time endowment economy. The aggregate en-
dowment process is given by
D
t
= (1 +t),
where > 0. There is an additional state variable X
t
, which evolves according to
dX
t
= X
t
dt + dZ
t
,
where > 0 and Z is a Brownian motion under the objective probability measure.
Both agents have the same utility function with A(x) = 1 for x 1. We also
assume A(x) =
1
x
for x < 1 to preserve the Inada condition at zero. The utility
function thus exhibits decreasing absolute risk aversion for low levels of consumption
and constant absolute risk aversion for high levels of consumption.
Assume that agent A knows the true distribution, while agent B disagrees with A
and believes that Z has a drift. Assume that the disagreement is constant, = 0, and
13
therefore the dierence in agents beliefs is described by the density process

t
= exp
_

1
2

2
t + Z
t
_
. (12)
Agents beliefs thus diverge asymptotically, with lim
t

t
= 0. Then,
1. If >
2
/2, agent B survives in the long run and exerts long-run impact on
prices;
2. If <
2
/2, agent B fails to survive in the long run and does not exerts long-run
impact on prices;
3. If =
2
/2, agent B fails to survive in the long run but exerts long-run impact
on prices.
Since there is no aggregate uncertainty and investors have the same preferences
and equal initial endowments, dierences in consumption between the two agents are
driven by their beliefs. Investors act to smooth their marginal utilities, as modied
by their beliefs, granting more consumption to an agent in states that agent believes
are relatively more likely. This happens even in the case in which disagreement is
over events that are irrelevant to the aggregate endowment.
Our example cover cases in which the aggregate endowment grows faster, slower,
or at the same rate as the agents beliefs diverge. The key comparison is the rate of
growth of belief dierences and hence the rate of growth of consumption dierences
with the level of aggregate consumption.
In addition, this example illustrates the importance of endowment growth overall.
The two cases in which agent B survives or has price impact, (i) and (iii) are impossible
without a growing endowment. We show in Sections 4 and 5 that this result can be
made general: a necessary condition for either price impact or survival is that the
endowment is unbounded.
In the rst case, (i), aggregate consumption grows fast enough to outpace the
dierence in beliefs and agent B both survives and has price impact. Here, belief dif-
ferences drive a wedge between agents consumptions, but that wedge is small relative
to the size of the economy, and so agent B can survive and exert price impact. In the
second case, (ii), aggregate consumption grows slowly, and so the wedge that belief
dierences creates between the two consumption levels is large relative to aggregate
consumption. Thus, agent B does not survive and cannot exert price impact.
14
In the third case, (iii), aggregate consumption grows at an intermediate level.
Here, belief dierences create consumption dierences that are large enough relative
to the aggregate endowment that agent B cannot survive. However, changes in the
belief dierences over time can still drive changes in the consumption allocations:
consumption levels are volatile enough that marginal utilities are aected. In par-
ticular, as we show in the appendix, lim
t
C
B,t
Dt
= 0, while limsup
t
C
B,t
= .
This means that for large enough t, A(C
A,t
) = 1, while, whenever C
B,t
> 1, Pareto
optimality implies C
A,t
=
1
2
D
t

1
2
ln(
t
) =
1
2
(1 ln Z
t
). As we discuss in
the introduction, agent B can exert nontrivial impact on prices if he is able to pro-
vide agent A with nontrivial risk sharing in the long run. This is the case in our
example. The conditional volatility of the marginal utility of agent A is equal to
vol(dm
t
) = A(C
A,t
)vol(dC
A,t
) = /2. In contrast, if agent B had the same beliefs as
A, the volatility of the stochastic discount factor would be zero (since the aggregate
endowment is deterministic). Because agent B maintains non-vanishing volatility of
his consumption changes in equilibrium, his beliefs distort equilibrium prices asymp-
totically.
Figure 1 illustrates the tradeo between endowment growth and belief divergence
in the economy described in Example 3.1. Specically, Figure 1 shows the median
path of the economy in each of the three cases considered in Example 3.1, plotted
against level curves for the consumption share of agent B (solid lines). The median
path of the economy is obtained by setting the driving Brownian motion Z
t
to zero.
Each level curve represents pairs (D, ln()) that give rise to a particular consumption
share w. These lines depend only on preferences, and they can be found by xing
w and plotting the value of ln() as a function of D, with the function given by the
Pareto optimality condition (7). Note that, because of constant absolute risk aversion
at high consumption levels, a given dierence in consumption shares requires a larger
dierence in beliefs at higher endowment levels. This explains why the level curves
tend to be spaced wider at higher endowment levels.
The economy illustrated in Figure 1 is growing, since > 0, and so the median
path is traced from left to right as time passes. In case (i), the median path (marked
with circles) does not cross the level curves for large t, which shows that as the
economy grows over time, the consumption share of agent B along the median path
converges to a constant, and hence agent B survives. In case (ii), the median path
(marked with squares) crosses consumption-share level curves from above, showing
that as the economy grows, agent Bs consumption share vanishes. Since the rate for
15
0 5 10 15 20 25
25
20
15
10
5
0
Endowment (D)
B
e
l
i
e
f

D
i
v
e
r
g
e
n
c
e

(

l
n

(

)
)
w = 0.01
w = 0.05
w = 0.09
w = 0.13
w = 0.17
w = 0.21
w = 0.25
w = 0.29
w = 0.33
w = 0.37
w = 0.41
w = 0.45
w = 0.49
Figure 1: Survival.This gure illustrates survival results in Examples 3.1 and
3.2. We set = 1. We plot the aggregate endowment D on the horizontal axis,
and belief divergence, ln(), on the vertical axis. Solid lines are the level curves for
the consumption share of agent B, so that each solid line plots pairs (D, ln()) that
give rise to a given consumption share w. These pairs can be found by xing w and
plotting the value of ln() as a function of D, with the function given by the Pareto
optimality condition (7). Labels for agent Bs consumption share are shown alone
the right margin. The marked lines show the median path (Z
t
= 0) of (D
t
, ln(
t
))
for each case in Example 3.1. We choose = 0.5 and set in cases (i), (ii), and
(iii) to
2
,
2
/4, and
2
/2 respectively. We mark the corresponding median paths
with circles, squares, and triangles.
belief divergence is identical in all three cases, the only reason why the three median
paths have dierent slopes is because of the dierent growth rates of the endowment
process. Slow endowment growth (and hence slow growth of risk aversion) generates
a steep median path, leading to agent Bs extinction. The median path for case
(iii) (marked with triangles) also crosses consumption-share level curves from above,
showing that agent Bs consumption share vanishes as the economy grows. The
dierence between cases (ii) and (iii) is in the rate at which agent Bs consumption
share vanishes. The rate of extinction is lower in case (iii), allowing agent B to retain
impact on prices in the long run.
In Example 3.1, the aggregate endowment process is deterministic. The same con-
16
clusions carry over to a setting in which the two agents disagree about the distribution
of the aggregate endowment process, as we show in the Example 3.2 below.
Example 3.2 We modify Example 3.1 so that there is aggregate risk and agents
disagree over the evolution of the aggregate endowment process. The aggregate en-
dowment process is now given by
D
t
= (1 +t)e
Xt
,
dX
t
= X
t
dt + dZ
t
.
Then,
1. If >
2
/2, agent B survives in the long run and exerts long-run impact on
prices;
2. If <
2
/2, agent B fails to survive in the long run and does not exerts long-run
impact on prices;
3. If =
2
/2, agent B fails to survive in the long run but exerts long-run impact
on prices.
3.2 Beliefs
Our second set of examples illustrates extinction and survival in an economy with
two Bayesian learners.
Example 3.3 Consider a continuous-time economy with the aggregate endowment
given by a geometric Brownian motion:
dD
t
D
t
= dt + dZ
t
, D
0
> 0.
Assume that the two agents have logarithmic preferences: U(c) = ln(c) and that they
do not know the growth rate of the endowment process. The agents start with Gaussian
prior beliefs about , N(
i
, (
i
)
2
), i {A, B}, and update their beliefs based on the
observed history of the endowment process according to the Bayes rule. Then, if both
agents have non-degenerate priors (min(
A
,
B
) > 0), then both agents survive in the
long run. If agent A knows the exact value of the endowment growth rate but agent
B does not, i.e.,
B
>
A
= 0, then agent B fails to survive.
17
In the above example, both agents beliefs tend to the true value of the unknown
parameter asymptotically. Survival depends on the relative rate of learning. If both
agents start not knowing the true value of , then, regardless of the bias or precision
of their prior, they both learn at comparable rates. Formally, the ratio of the agents
belief densities converges to one, lim
t

t
= 1. However, if one agent starts with
perfect knowledge of the true parameter value, the rate of learning of the other agent
is not sucient to guarantee that agents survival.
8
Our second example is motivated by Dumas et al. (2009), who study an economy
with an irrational (overcondent) agent who fails to account for noise in his signal
during the learning process. We do not model the learning process of the overcondent
agent explicitly, as Dumas et al. (2009) do, but instead postulate a qualitatively
similar belief process exogenously.
Example 3.4 Consider a discrete-time economy with uncertainty described by the
i.i.d sequence of independent normal variables (
t
, u
t
) N(0, I). Aggregate endow-
ment is given by
D
t
= D
t1
exp (
t1
+
t
) , D
0
> 0,
where the conditional growth rate of the endowment,
t1
is a stationary moving
average of the shocks
t1
,
t2
, .... Assume that agent A knows the true value of
t
,
but agent B, who is not a Bayesian learner, observes it with noise. Specically, agent
Bs estimate of the current growth rate of the endowment is given by
t1
+
t1
,
where
t
follows a nite-order moving average process driven by u
t
. Assume that both
agents have logarithmic preferences. Then, agent B fails to survive in the long run.
The moving-average representation of the expected growth rate of the endowment
captures the special case of a Bayesian learner who faces an unobservable expected
growth rate that follows a low-order autoregressive process. Thus, one can interpret
the objective distribution of the endowment process in our example as the beliefs of
a Bayesian learner A. In contrast, agent B does not follow the Bayes rule, and we
capture his mistakes by adding noise to his forecasts of endowment growth. Agent
Bs errors follow a stationary process and thus do not diminish over time. Agent
8
Our example builds on the models of Basak (2005) and Detemple and Murthy (1994). See also
Blume and Easley (2006) for further discussion of Bayesian learning and its implications for survival.
18
Bs beliefs diverge from the Bayesian learners probability measure asymptotically,
lim
t

t
= 0, and therefore he fails to survive.
The above examples emphasize the importance of the requirement that
t
0,
which is our usual condition on belief dispersion. In Example 3.3, both agents are
making errors and learning at the same rate, and thus their relative errors do not
accumulate fast enough for beliefs to diverge over time. When one agent does not
make errors, the relative error of the other agent does accumulate fast enough so he
fails to survive. But this divergence of beliefs does take place in Example 3.4 due to
a biased learning process.
3.3 Preferences
We now illustrate how survival depends on preferences. We consider a family of
economies with state-independent preferences that dier only with respect to the
agents utility function. For the agent making relatively incorrect forecasts to become
extinct, the agent making more accurate forecasts must bet suciently aggressively on
his beliefs. If agents are too risk averse at high consumption levels, they do not bet on
their beliefs enough, and the agent with relatively inaccurate beliefs can survive and
have price impact. This result bears similarity to the nding that inferior forecasters
can survive in incomplete market economies, since the agents are limited in their
ability to bet on their beliefs by the available menu of nancial assets. Whether the
agents lack willingness to bet on their beliefs due to risk aversion, or face constraints,
the end result is that agents with inferior forecasts are able to survive.
Example 3.5 Consider a continuous-time economy with the aggregate endowment
given by a geometric Brownian motion:
D
t
= exp (t + Z
t
) , D
0
> 0, , > 0.
Assume that agent A uses the correct probability measure, A = P, but agent B has a
constant bias, = 0, in his forecasts of the growth rate of the endowment. Therefore,

t
= exp
_

1
2

2
t + Z
t
_
.
Let the absolute risk aversion function be A(x) =
1
x
for x < 1 to preserve the Inada
19
condition at zero, and
A(x) = x

, 0.
for x 1. Then, if risk aversion is declining rapidly enough, 1, agent B does
not survive and does not aect prices asymptotically. If risk aversion declines only
slowly, (1, 0], then agent B survives and has price impact in the long run.
Decreasing absolute risk aversion (DARA) is a weak a priori restriction on utility
functions, and within this family of preferences, we can see how changes in the shape
of the risk aversion function aect survival. When high levels of consumption generate
a high propensity to accept gambles risk aversion declines rapidly in consumption
agent B does not survive or have price impact.
4 Survival
In this section we present general necessary and sucient conditions for survival.
The following theorem shows formally how survival depends on a three-way tradeo
between endowments, beliefs, and preferences.
Theorem 4.1 A necessary condition for agent B to become extinct is that for all
(0,
1
2
),
limsup
t
_
(1)Dt
Dt
A(x) dx
| ln(
t
)|
1, Pa.s. (13)
A sucient condition for his extinction is that the inequality is strict, i.e., for all
(0,
1
2
),
limsup
t
_
(1)Dt
Dt
A(x) dx
| ln(
t
)|
< 1, Pa.s. (14)
From the conditions in Theorem 4.1, it is clear that survival depends on the joint
properties of aggregate endowments (D
t
), preferences (in particular, risk aversion
A(x)), and beliefs (
t
). Survival is determined by the relation between the rate of
belief divergence and the rate of decline of risk aversion evaluated at the aggregate
endowment. Theorem 4.1 formalizes the informal discussion in the introduction. If
20
risk aversion declines suciently slowly, the numerator in (13) dominates and agent
B survives. Intuitively, the numerator captures the relation between dierences in
consumption and dierences in marginal utilities between the two agents. The Pareto
optimality condition (6) implies that if beliefs of the two agents diverge, so must their
marginal utilities evaluated at their equilibrium consumption. But if risk aversion
declines too slowly, increasing dierences in marginal utilities fail to generate large
dierences in consumption. Equation (13) provides the precise restriction on the rate
of decline in risk aversion necessary for agent Bs extinction.
Next, we place strict restrictions on one of the primitives, and in doing so, we
eliminate interactions between the endowment, beliefs, and preferences, simplifying
the results. The following straightforward applications of Theorem 4.1 identify a
broad class of models in which agent B does not survive. These results replace the
joint condition on the primitives in Theorem 4.1 with an easily veriable condition on
only one of the primitives: the utility function in Corollary 4.2 and the endowment
process in Corollary 4.3.
Corollary 4.2 If risk aversion is bounded so that A(x) Cx
1
, and lim
t

t
= 0,
then agent B never survives.
If risk aversion is bounded as in Corollary 4.2, then large dierences in marginal
utilities imply large dierences in consumption. Therefore, when beliefs diverge, agent
B does not survive. The class of models with bounded risk aversion in the manner of
Corollary 4.2 is quite large. It includes, for instance, all utilities of HARA (hyperbolic
absolute risk aversion) type, except for the CARA (constant absolute risk aversion)
utility.
If the endowment process is bounded, then large dierences in marginal utilities
require one agents consumption to go to zero. Sandroni (2000) and Blume and Easley
(2006) study models with bounded endowment and diverging beliefs and nd that
agent B fails to survive regardless of the exact form of preferences. We replicate this
result as a consequence of Theorem 4.1.
Corollary 4.3 If the aggregate endowment process is bounded away from zero and
innity and lim
t

t
= 0, then agent B never survives.
In models covered by Corollaries 4.2 and 4.3, we sharpen the survival results
further by establishing the rate of extinction of agents with inferior beliefs. In par-
21
ticular, in models satisfying restrictions on risk aversion as in Corollary 4.2, the rate
of extinction is directly related to the rate of divergence in beliefs.
Proposition 4.4 If risk aversion is bounded so that Cx
1
A(x) Cx
1
, and
lim
t

t
= 0, then for t large enough that
t
< 1, agent Bs consumption share
satises
(
t
)
1/C
1 + (
t
)
1/C
w
t

(
t
)
1/C
1 + (
t
)
1/C
(
t
)
1/C
. (15)
The rate of extinction is proportional to the rate of belief divergence. For instance,
consider the specication of endowment and beliefs as in Example 3.1. Under the
preference restrictions in Proposition 4.4, agent Bs consumption share approaches
zero exponentially at the rate bounded between
1
2
C
2
and
1
2
C
2
. As Fedyk et al.
(2010) make clear, the rate of belief divergence in realistic settings can be arbitrar-
ily high if agents disagree on the distribution of multiple sources of randomness.
Thus, our convergence rate result shows that extinction happens at very high rates
in economies with quantitatively large disagreement between agents, or at very slow
rates in economies with mild degrees of disagreement.
We obtain a similar characterization of extinction rates in economies with bounded
dividends.
Proposition 4.5 If the aggregate endowment process is bounded away from zero and
innity, 0 < D D
t
D < , and lim
t

t
= 0, then for t large enough that

t
< 1, agent Bs consumption share satises
1
D
(u

)
1
_
u

(D/2)

t
_
w
t

1
D
(u

)
1
_
u

(D)

t
_
As in Proposition 4.4, we nd that the rate of extinction of agent B is directly related
to the rate of belief divergence. However, the relationship between the two is modu-
lated by the assumed utility function. Qualitatively, the sharper the rise in marginal
utility as consumption level approaches zero, the lower the rate of extinction. For
instance, with CRRA preferences, the rate of extinction is proportional to the rate
of belief divergence. It is clear, however, that without restricting preferences it is
impossible to place tighter bounds on the rate of extinction.
If the endowment process and the risk aversion coecient are not bounded, then
the precise relation between the primitives is important in determining agent Bs
22
survival. We simplify the conditions of Theorem 4.1 for the class of utilities with
(weakly) decreasing absolute risk aversion (DARA), which is generally considered to
be the weakest a priori restriction on utility functions.
Proposition 4.6 Suppose that the utility function exhibits DARA. Then, for agent
B to go extinct it is sucient that there exists a sequence
n
(0,
1
2
) converging to
zero such that for any n
lim
t
A(
n
D
t
)D
t
| ln(
t
)|
= 0, Pa.s. (16)
For agent B to survive, it is sucient that for some (0,
1
2
)
Prob
_
limsup
t
A(D
t
)D
t
| ln(
t
)|
=
_
> 0. (17)
If, in addition,
lim
t
A(D
t
)D
t
| ln(
t
)|
= , Pa.s. (18)
then lim
t
w
t
=
1
2
, Pa.s.
This proposition claries the three-way tradeo between beliefs, endowments, and
preferences that determines survival. Intuitively, given the endowment growth rate
in the economy, agents with inferior beliefs fail to survive if risk aversion declines
suciently fast with the consumption level, or if beliefs diverge at a suciently high
rate.
We nally consider a generalization of the setting analyzed in Kogan et al. (2006)
and Yan (2008), where endowment follows a Geometric Brownian motion and agent
B is persistently optimistic about the growth rate of the endowment. We make a
weaker assumption that the endowment and belief dierences grow at proportional
asymptotic rates, i.e. lim
t
ln(Dt)
| ln(t)|
= b < . Such models, with geometric Brownian
motion specications for D and in particular, are very common in the literature.
Corollary 4.7 Consider an economy with lim
t
ln(Dt)
| ln(t|)
= b < and lim
t

t
= 0,
Pa.s. Assume that the utility function is of DARA type. Then agent B becomes extinct
23
if
lim
x
A(x)
1
x
| ln(x)|
= 0. (19)
Agent B survives if
lim
x
A(x)
1
x
| ln(x)|
= , (20)
We thus identify two broad classes of preferences for which survival does and does
not take place under the above assumption on the endowment and beliefs. Agent B
becomes extinct if risk aversion at high consumption levels declines rapidly enough,
and he survives if risk aversion declines suciently slowly. Models with CRRA pref-
erences and Geometric Brownian motions for D and satisfy condition (19), since
A(x)
1
x
| ln(x)|
=

| ln(x)|
0, and therefore the agent with inferior beliefs becomes extinct in
such economies.
5 Price Impact
We now consider the inuence agent B has on the long-run behavior of prices and how
this inuence is related to his survival. Below we identify broad classes of economies
in which the agent making relatively inaccurate forecast does or does not have impact
on prices in the long run.
As we have have shown in Corollaries 4.2 and 4.3, if risk aversion declines su-
ciently rapidly with consumption level, or if the aggregate endowment is bounded,
the agent with inferior beliefs does not survive. In these cases, this agent also has no
price impact in the long run:
Proposition 5.1 If risk aversion is bounded such that A(x) Cx
1
, and lim
t

t
=
0, then the B agent has no price impact.
Proposition 5.2 If the aggregate endowment process is bounded away from zero and
innity, and lim
t

t
= 0, then agent B has no price impact.
The relation between Arrow-Debreu prices and marginal utilities means that agent
B can aect prices if he has nontrivial impact on the marginal utility of agent A. When
risk aversion declines at a high enough rate, this requires him to have signicant
24
impact on consumption growth of agent A. This in turn is impossible since agent B
does not survive. Similarly, in economies with bounded aggregate endowment, agent
B cannot have signicant impact on consumption growth for agent A, and so agent
B cannot have price impact.
In addition to showing that agent B has no long-run impact on prices in economies
covered by Propositions 5.1 and 5.2, we characterize how rapidly price impact of agent
B disappears. As a measure of the magnitude of price impact, we use
PI(t, s;

= 0) ln
_
m
t+s
()/m
t
()
m

t+s
(0)/m

t
(0)
_
=
_
D
t+s
D
t+s
(1w
t+s
)
A(x) dx
_
Dt
Dt(1wt)
A(x) dx.
We use the reference economy with utility weight

= 0 to dene our measure of

price impact. We do this because price impact of agent B vanishes asymptotically
with respect to the reference economy with

= 0 under either bounded coecients

of risk aversion or bounded endowments.
Proposition 5.3 If risk aversion is bounded so that A(x) Cx
1
, and lim
t

t
=
0, then, for t large enough that
t
< 1, the measure of price impact, PI(t, s;

= 0),
satises
|PI(t, s;

= 0)| C
_
(
t
)
1/C
+ (
t+s
)
1/C
_
In economies covered by Proposition 5.3, the distortion of the stochastic discount
factor created by Bs beliefs disappears at a rate at least proportional to the rate
of belief divergence. As shown in Proposition 4.5, Bs consumption share in such
economies also vanishes at the rate of belief divergence.
The price impact of agent Bs beliefs in economies with bounded aggregate en-
dowment vanishes at least as quickly as Bs consumption share:
Proposition 5.4 If the aggregate endowment process is bounded away from zero and
innity, 0 < D D
t
D < , and lim
t

t
= 0, then, for t large enough that

t
< 1, the measure of price impact, PI(t, s;

= 0), satises
|PI(t, s;

= 0)|
_
max
x[D/2,D]
A(x)
_
(w
t
+ w
t+s
)D,
where w
t
is the equilibrium consumption share of agent B.
25
As we show in Proposition 4.5, in economies with bounded aggregate endowment,
Bs consumption share vanishes at the rate directly related to the rate of belief diver-
gence. Since the exact extinction rate generally depends on preferences in a nonlinear
manner, we do not derive an explicit bound on price impact in Proposition 5.4 in terms
of the primitives, and instead express an upper bound on price impact in terms of
Bs consumption share.
When conditions on the primitives are relaxed, consumption and price dynamics
become more complicated. It is possible for agent B to aect the marginal utility of
agent A without having non-vanishing eect on agent As consumption growth, which
means that agent Bs price impact may be consistent with his extinction. We have
described such an economy in Example 3.1. We show below that the reverse is also
possible: agent B may survive without aecting prices.
Proposition 5.5 Consider an economy with DARA preferences in which
lim
t
A(
1
2
D
t
)D
t
(ln(
t
))
2
= , Pa.s. (21)
and lim
t

t
= 0. Then agent B survives and asymptotically consumes a half of the
aggregate endowment.
Proposition 5.6 In the economy dened in Proposition 5.5, agent B has long-run
price impact if and only if the belief process
t
has non-vanishing growth rate asymp-
totically, i.e., there exists s > 0 and > 0 such that
Prob
_
limsup
t
|ln(
t+s
) ln(
t
)| >
_
> 0. (22)
Moreover, asymptotically the state price density does not depend on the initial wealth
distribution, i.e., does not depend on .
Proposition 5.6 shows that survival does not necessarily lead to price impact.
Moreover, since under condition (21) the asymptotic consumption allocation does
not depend on the initial wealth distribution (each agent consumes one half of the
aggregate endowment), in the long run, the state price density does not depend on
the initial wealth distribution.
Proposition 5.7 helps shed light on why the survival and price impact properties
of various economies are connected to the rate of decrease in absolute risk aversion.
26
It states a general result for consumption sharing rules in economies with unbounded
relative risk aversion: if beliefs are homogeneous, the asymptotic consumption distri-
bution is independent of the initial wealth distribution.
Proposition 5.7 Consider an economy with homogeneous beliefs, growing endow-
ment process, D
t
as t . Assume that A(x)x is monotonically increasing
and unbounded. Then, for any initial allocation of wealth between the agents, their
consumption shares become asymptotically equal. Moreover, the state price density in
this economy is asymptotically the same as in an economy in which the agents start
with equal endowments.
As we know from Corollary 4.2 and Proposition 5.1, economies with rapidly de-
clining risk aversion exhibit simple behavior: agent B does not survive and has no
asymptotic impact on the state-price density. When absolute risk aversion is only
slowly declining, survival is also determined by belief dierences. Proposition 5.7
shows that in a homogeneous-belief economy consumption shares of the agents tend
to become equalized over time no matter how uneven the initial wealth distribution
is. Similarly, the state-price density does not depend (asymptotically) on the initial
wealth distribution.
The above convergence mechanism remains at work in economies with hetero-
geneous beliefs. However, there is another force present under belief heterogeneity:
agent B tends to mis-allocate his consumption across states due to his distorted be-
liefs, which reduces his asymptotic consumption share. The tradeo between the two
competing forces is intuitive: distortions in agents consumption shares caused by
belief dierences tend to disappear over time, unless the belief dierences grow su-
ciently rapidly. Condition (21) guarantees that beliefs do not diverge too quickly, and
thus agent B survives and consumes half of the aggregate endowment asymptotically.
Agent B can exert price impact as long as his beliefs diverge quickly enough from the
beliefs of agent A so that condition (22) holds.
6 State-Dependent Preferences
In this section, we generalize our results on survival and price impact to models with
state-dependent preferences. Let the utility function take the form u(C, H), where C
is agents consumption and H is the process for state variables aecting the agents
27
utility. We assume that H is an exogenous adapted process. This specication covers,
as an important special case, models of external habit formation, or catching-up-with-
the-Joneses preferences, as in Abel (1990) and Campbell and Cochrane (1999), in
which case the process H is a function of lagged values of the aggregate endowment.
As we show below, the general lessons of the previous sections apply to state
dependent preferences. However, the dependence of risk aversion variables other
than consumption level aects the validity of MSH in economies with state-dependent
preferences. The addition of state variables to the utility function means that the
coecient of risk aversion may be more variable, and, in particular, it may no longer
be bounded even with CRRA-like preferences.
Theorem 4.1 extends to the case of state-dependent preferences. Let A(C, H) and
(C, H) denote, respectively, the coecients of absolute and relative risk aversion at
consumption level C. Then we obtain an analog of Proposition 4.6:
Proposition 6.1 Assume that the utility function u(C, H) exhibits DARA: the coef-
cient of absolute risk aversion A(C, H) is decreasing in C. Then, for agent B to go
extinct it is sucient that there exists a sequence
n
(0,
1
2
) converging to zero such
that for any n
lim
t
A(
n
D
t
, H
t
)D
t
| ln(
t
)|
= 0, Pa.s. (23)
For agent B to survive, it is sucient that for some (0,
1
2
)
Prob
_
limsup
t
A(D
t
, H
t
)D
t
| ln(
t
)|
=
_
> 0. (24)
If, in addition,
lim
t
A(D
t
, H
t
)D
t
| ln(
t
)|
= , Pa.s. (25)
then lim
t
w
t
=
1
2
, Pa.s.
In a growing economy (D
t
, P a.s.) with diverging beliefs and state-
independent preferences, survival of agent B requires risk aversion to decline slowly
enough, so that limsup
D
A(D)D = (see Proposition 4.6). This is not the case
if preferences are state-dependent. In many common models with external habit for-
mation, the process H
t
is such that the process A(D
t
)D
t
is stationary. In such cases,
28
survival and price impact results are sensitive to the distributional assumptions on
beliefs and the aggregate endowment. In order for agent B to survive, the station-
ary distribution of risk aversion must have a suciently heavy right tail, so that the
condition (23) is violated. As an illustration, consider the following example of two
economies which dier only with respect to the distribution of endowment growth:
Example 6.2 Consider two discrete-time economies with external habit formation.
Let the relative risk aversion coecient of the two agents be
(x, H) = 1 +
_
x
H
_
1
,
where H
t
= D
t1
. Thus, agents external habit level equals the lagged value of the
aggregate endowment and the agent is more risk averse when his consumption is low
relative to his habit level. Assume that the disagreement process follows
ln(
t
) =
1
2
t +
t

n=1
Z
n
where Z
n
are distributed according to a standard normal distribution and are inde-
pendent of the endowment process.
Endowment growth is independently and identically distributed over time in both
economies. Assume that the endowment process D
t
is independent of the disagree-
ment process
t
, which means that agents A and B disagree on probabilities of payo-
irrelevant states.
910
In the rst economy, endowment growth has bounded support,
0 < g
Dt
D
t1
g < . In the second economy, g = 0. Moreover, the distribution of
endowment growth is such that for suciently small x,
Prob
_
D
t
D
t1
< x
_
> x
1/3
.
Then, agent B becomes extinct in the rst economy, and survives in the second econ-
9
Another example of an economy in which belief dierences are independent of the aggregate
endowment is a multi-sector economy in which agents agree on the distribution of the aggregate
endowment, but disagree about the distribution of sectors shares in the aggregate endowment.
10
Survival results in this example do not depend on the joint distribution of the endowment
process and the disagreement process. Thus, one may assume that the two agents disagree about
the probabilities of payo-relevant states by specifying
Dt
Dt1
to be a nonlinear function of Z
t
. The
assumption of independence of endowment and beliefs makes it easy to establish price impact results
below.
29
omy.
In the rst economy, it is clear that condition (23) is satised for any positive

n
, and thus agent B does not survive. In the second economy, the distribution of
endowment growth is such that relative risk aversion exhibits frequent large spikes,
namely
Prob
_
A(D
t
, H
t
)D
t
> t
3
_
= Prob
_
1 +
D
t1
D
t
> t
3
_
Prob
_

D
t
D
t1
< t
3
_
>
1/3
t
1
.
Such spikes in risk aversion occur frequently enough that the condition (24) holds.
11
The following propositions extends our results on price impact to economies with
state-dependent preferences. Their proofs follow closely the results of Sections 4 and
5.
Proposition 6.3 There is no price impact or survival in models with bounded risk
aversion such that A(x) Cx
1
.
In the model with state-independent preferences, bounding the endowment pro-
cess implies bounding risk aversion. This, in turn, implies a lack of price impact. With
state-dependent preferences, a bounded endowment no longer implies that risk aver-
sion is bounded, and therefore there is no analog to the Corollary 4.3 and Proposition
5.2 for the economies with state-dependent preferences.
The following proposition shows that survival of agent B is not sucient for his
long-run impact on prices.
Proposition 6.4 Consider a model with the utility function of DARA type, with
A(x, H)x monotonically increasing x. Assume that
lim
t
A(
1
2
D
t
, H
t
)D
t
(ln(
t
))
2
= , Pa.s., (26)
Then agent B survives and asymptotically consumes a half of the aggregate endow-
ment. He has price impact if and only if the disagreement process
t
is such that its
growth rate does not vanish asymptotically, i.e., there exists s > 0 and > 0 such
11
Since

t=1
t
1
= , the Borel-Cantelli lemma implies that limsup
t
A(D
t
, H
t
)D
t
t
3

1 P a.s. Since lim

t
| ln(
t
)|t
3
= 0 P a.s., (24) follows.
30
that
Prob
_
limsup
t
|ln(
t+s
) ln(
t
)| >
_
> 0. (27)
Moreover, asymptotically the state-price density does not depend on the initial wealth
distribution, i.e., does not depend on .
Returning to Example 6.2, note that agent B has no price impact in the rst
economy but exerts price impact in the second economy. The rst result follows
immediately from Proposition 6.4, since bounded dividend growth implies bounded
relative risk aversion in this economy. The second result can be established using a
slight modication of the proof of Proposition 5.6.
12
7 Conclusion
In this paper we examine the economic mechanism behind the Market Selection Hy-
pothesis and establish necessary and sucient conditions for its validity in a general
setting with minimal restrictions on endowments, beliefs, or utility functions. We
show that the MSH holds in economies with bounded endowments or bounded rela-
tive risk aversion. The commonly studied special case of constant relative risk aversion
preferences belongs to this class of models. However, we show that the MSH cannot
be substantially generalized to a broader class of models. Instead, survival is deter-
mined by a comparison of the forecast errors to risk attitudes. The price impact of
inaccurate forecasts is distinct from survival because price impact is determined by
the volatility of traders consumption shares rather than by their level. We show a
new mechanism by which an agent who fails to survive in the long run can exert
persistent impact on prices. This phenomenon exists because the disappearing agent
can provide a non-trivial degree of risk sharing in equilibrium. Our results also apply
to economies with state-dependent preferences, such as external habit formation.
12
As we show above, limsup
t
Dt
Dt1
t
3
1, Pa.s., while lim
t
| ln(
t
)|
2
t
3
= 0, Pa.s.,
implying that limsup
t
A(D
t
, H
t
)D
t
/| ln(
t
)|
2
= , Pa.s. The price impact result then follows
from independence of D
t
and
t
and the assumption that increments ln(
t
)ln(
t1
) are independent
across time.
31
A Appendix
A.1 Examples 3.1 and 3.2
First, we establish survival results. Consider the Pareto optimality condition (7). w
t
is given by
w
t
=
1
2
_
1 +
ln(
t
)
D
t
_
(A1)
if it satises w
t
D
t
> 1, i.e., (A1) describes the equilibrium consumption share of agent
B if
1
2
(ln(
t
) + D
t
) > 1. (A2)
Given the specication of the beliefs and the endowment process,
lim
t
1
2
_
1 +
ln(
t
)
D
t
_
=
1
2
_
1

2
/2

_
a.s.
In case (i), >
2
/2, and therefore (A2) is satised for large enough t. Then,
(A1) holds and lim
t
w
t
> 0, thus agent B survives.
In case (ii), <
2
/2, and therefore, for large enough t, (A2) is violated. We
conclude then that, for large enough t, w
t
D
1
t
, and therefore agent B fails to
survive.
In case (iii), either (A2) holds, or w
t
D
t
1, so that
w
t
min
_
D
1
t
,
1
2
_
1 +
ln(
t
)
D
t
__
.
Since both terms on the right-hand-side converge to zero almost surely, we conclude
that agent B fails to survive.
Next, we establish the price impact results. Consider a reference economy (
t
= 1)
with the utility weight

0. The Pareto optimality condition (7) implies that

ln(

) =
_
(1w

t
)Dt
w

t
Dt
A(x) dx,
where w

t
is the consumption share process of agent B. Since lim
t
D
t
= , this
32
implies that for almost every path of the economy, for large enough t,
w

t
=
_
1
2
_
1 +
ln(

)
Dt
_
,

> 0,
0,

= 0.
Then, the ratio of the pricing kernel in the heterogeneous-belief economy to the one
in the reference economy is given by
m
t
m

t
=
_
e
Dtwt
1
2
Dt
1
2
ln(

)
,

> 0,
e
Dtwt
,

= 0.
(A3)
Consider case (i), >
2
/2. In this case, lim
t
w
t
= w

> 0 a.s. Thus, for almost

every path of the economy, for large enough t,
w
t
D
t
=
1
2
(D
t
+ ln(
t
)) .
To show that there exists price impact, we must show that ln
_
m
t+s
m

t+s
m

t
mt
_
does not
converge to zero. For large enough t,
ln
_
m
t+s
m

t+s
m

t
m
t
_
=
_
_
_
1
2
_

2
2
s + (Z
t+s
Z
t
)
_
,

> 0,
1
2
_
D
t+s
D
t

2
2
s + (Z
t+s
Z
t
)
_
,

= 0,
The fact that Z
t+s
Z
t
N(0, s) is independent of ltration at t establishes that
there is price impact in case (i) for

> 0. The case of

= 0 follows an analogous
argument.
In case (ii), <
2
/2 and thus lim
t
Dt
| ln(t)|
= 0 a.s. The Pareto optimality then
states that for almost every path of the economy, for large enough t,
D
t
(1 w
t
) 1 ln(w
t
D
t
) = ln(
t
)
and therefore lim
t
w
t
D
t
= 0 a.s.. This implies that there is no price impact relative
to the benchmark economy with

= 0.
In case (iii), =
2
/2 and therefore limsup
t
w
t
D
t
= . Then, for almost every
path, there exists an unbounded increasing sequence of times t
k
such that w
t
k
D
t
k
> 1.
33
For t = t
k
, using (A1), the ratio
mt
m

t
is given by
m
t
m

t
=
_
e
1
2
ln(t)
1
2
ln(

)
,

> 0,
e
Dtwt
,

= 0.
(A4)
Since, along such a sequence, Z
t
k
+s
Z
t
k
> ||s innitely often, we can select a further
subsequence t

k
, such that w
t

k
D
t

k
> 1 and Z
t

k
+s
Z
t

k
> ||s. Note that this implies
that w
t

k
+s
D
t

k
+s
> 1 and therefore
m
t

k
+s
m

k
+s
is also given by (A4). Then, for

> 0,
ln
_
m
t

k
+s
m

k
+s
m

k
m
t

k
_
=
1
2
_

2
2
s + (Z
t

k
+s
Z
t

k
)
_
and therefore ln
_
m
t

k
+s
m

k
+s
m

k
m
t

k
_
>
2
s/4. Thus, ln
_
m
t+s
m

t+s
m

t
mt
_
fails to converge to zero on
a set of measure one and we conclude that there exists price impact for

> 0. The
case of

= 0 follows an analogous argument.

A.2 Example 3.3
Dene
A
t
=
A
t
. Then, using the Kalman Filter,
d
A
t
=
A
t

A
t
dt +
A
t
dZ
t
and d
A
t
=
_

A
t
_
2
dt
and therefore

A
t
=

A
0

A
0
t + 1
+

A
0

A
0
t + 1
Z
t
.
Next, from the denition of
A
t
, we have
ln(
A
t
) =
1
2
_
t
0
_

A
s
_
2
ds +
_
t
0

A
s
dZ
s
=
_
t
0
_
1
2
_

A
0
_
2 1
(
A
0
s + 1)
2
+
1
2
_

A
0
_
2 1
(
A
0
s + 1)
2
Z
2
s
+
A
0

A
0
1
(
A
0
s + 1)
2
Z
s
_
ds
+
_
t
0

A
s
dZ
s
. (A5)
34
Integration by parts yields
_
t
0

A
s
dB
s
=
_
t
0
_

A
0

A
0
s + 1
+

A
0

A
0
s + 1
Z
s
_
dZ
s
=
1
2

A
0

A
0
t + 1
Z
2
t
+

A
0

A
0
t + 1
Z
t
+
_
t
0
_

1
2

A
0

A
0
s + 1
+
1
(
A
0
s + 1)
2
_
1
2
_

A
0
_
2
Z
2
s
+
A
0

A
0
Z
s
__
ds. (A6)
Plugging the last equation into the expression for ln(
A
t
) results in
ln(
A
t
) =
1
2

A
0

A
0
t + 1
Z
2
t
+

A
0

A
0
t + 1
Z
t

_
t
0
1
2
_

A
0
_
2 1
(
A
0
s + 1)
2
ds
_
t
0
1
2

A
0

A
0
s + 1
ds
The sum of the rst three terms in the above expression converges to a constant (using
elementary properties of the Brownian motion, Z
2
t
/t 1 and Z
t
/t 0, and the third
term converges to (1/2)
_

A
0
_
2
/
A
0
). The fourth term equals (1/2) ln(1 +
A
0
t), and
we thus nd
lim
t
ln(
A
t
)
2 ln(t)
= 1,
with the same result for agent B.
If min(
A
,
B
) > 0, then
t
1, and so (7) with A(x) = x
1
implies that both
agents survive. If
B
>
A
= 0, then
B
t
=
t
0, and so Proposition 4.6 implies that
B does not survive.
A.3 Example 3.4
Agent Bs beliefs are characterized by the density process

t
= exp
_
t

s=1
_

2
s1
2
+
s1

s
_
_
,
where
t
=
t
/. The process M
t
=

t
s=1

s1

s
is a martingale.
Since lim
t
_
1
t

t
s=1

2
s1
_
= E[
2
t
], the quadratic variation process of M
t
con-
verges to innity almost surely under P, and therefore lim
t
M
t
/
_
t
s=1

2
s1
_
=
0, P a.s. (see Shiryaev 1996, 7.5, Th. 4). This implies that lim
t

t
= 0 a.s. and
hence the condition (16) in Proposition 4.6 is satised. We conclude that agent B
35
does not survive in the long run.
A.4 Example 3.5
Survival results follow from Proposition 4.6, since the logarithm of the belief density
ratio ln(
t
) exhibits linear growth, while the aggregate endowment D
t
grows expo-
nentially. Price impact results follow from Proposition 5.6.
A.5 Proof of Theorem 4.1
Suppose that agent B becomes extinct, i.e., w
t
=
C
B,t
Dt
converges to zero almost surely.
For each element of the probability space for which w
t
vanishes asymptotically, one
can nd T(), such that w
t
< for any t > T(). Since
_
(1w)D
wD
A(x) dx is a decreasing
function of w, the rst-order condition (7) implies that for all t > T()
1 =
_
(1wt)Dt
wtDt
A(x) dx
ln(
t
)

_
(1)Dt
Dt
A(x) dx
ln(
t
)
.
Thus, the desired result follows by applying limsup
t
to both sides of the inequality.
We now prove the sucient condition. Consider the elements of the probability
space for which limsup
t
_
(1)D
t
D
t
A(x) dx
| ln(t)|
< 1 for any > 0. For each such realization,
we can dene T() and > 0, such that
_
(1)Dt
Dt
A(x) dx
| ln(
t
)|
1
for all t > T(). If limsup
t
w
t
= 0, then one can always nd > 0 and t > T(),
such that w
t
> . But then
1 =
_
(1wt)Dt
wtDt
A(x) dx
ln(
t
)

_
(1)Dt
Dt
A(x) dx
ln(
t
)
.
Taking limsup
t
on both sides, implies 1 1 , which is a contradiction.
36
A.6 Proof of Corollary 4.2
By assumption xA(x) < C for all x and C > 0. Then,
_
(1)Dt
Dt
A(x) dx
| ln(
t
)|
C
ln() ln(1 )
| ln(
t
)|
which converges to zero almost surely as t .
A.7 Proof of Corollary 4.3
Let D and D denote the upper and lower bound of D
t
, 0 < D D. Let A()
denote the maximum of A(x) on [D, (1 )D]. We then have
_
(1)Dt
Dt
A(x)dx
_
(1 )D D
_
A(), which is nite. Given that
t
0 as t and hence | ln(
t
)|
approaches innity, we conclude that (14) holds, and agent B does not survive.
A.8 Proof of Proposition 4.4
We establish the upper bound. Derivation of the lower bound is analogous. Using
the Pareto optimality condition and the restriction A(x) Cx
1
,
ln
t
=
_
(1wt)Dt
wtDt
A(x)dx
_
(1wt)Dt
wtDt
Cx
1
dx = C ln
1 w
t
w
t
,
which implies
w
t
1 w
t
(
t
)
1/C
.
The upper bound then follows.
A.9 Proof of Proposition 4.5
Using Pareto optimality condition and concavity of the utility function,

t
=
u

((1 w
t
)D
t
)
u

(w
t
D
t
)

u

(D)
u

(w
t
D
t
)
,
37
which implies
u

(w
t
D
t
)
u

(D)

t
and therefore
w
t

1
D
t
(u

)
1
_
u

(D)

t
_

1
D
(u

)
1
_
u

(D)

t
_
.
Similarly, to derive the lower bound, use

t
=
u

((1 w
t
)D
t
)
u

(w
t
D
t
)

u

(D/2)
u

(w
t
D
t
)
,
which implies
u

(w
t
D
t
)
u

(D/2)

t
and therefore
w
t

1
D
t
(u

)
1
_
u

(D/2)

t
_

1
D
(u

)
1
_
u

(D/2)

t
_
.
A.10 Proof of Proposition 4.6
Since A(x) is a non-increasing function,
_
(1

)D

D
A(x) dx
_
D

D
A(x) dx A(D)D(

),
where 0 <

< . Condition (17) then implies that

limsup
t
_
(1

)Dt

Dt
A(x) dx
| ln(
t
)|
= , Pa.s.,
and hence a necessary condition for extinction is violated. Thus, agent B survives.
Next, for any (0, 1/2) , nd
n
< . Then, since since A(x) is a non-increasing
function,
_
(1)D
D
A(x) dx A(D)D(1 2) A(
n
D)D(1 2)
38
Then,
_
(1)Dt
Dt
A(x) dx
| ln(
t
)|

A(
n
D
t
)D
t
(1 2)
| ln(
t
)|
,
and the result follows from (14).
Lastly, since the utility function is of DARA type, condition (7) implies that
| ln(
t
)| A((1 w
t
)D
t
)D
t
(1 2w
t
)
and therefore, using condition (18), lim
t
w
t
= 1/2.
A.11 Proof of Corollary 4.7
Consider a set (of measure one) of s for which lim
t
ln(Dt)
| ln(t)|
= b and lim
t

t
= 0.
On this set,
lim
t
A(D
t
)D
t
| ln(
t
)|
= lim
t
1
Dt
ln(D
t
)
| ln(
t
)|
A(D
t
)D
t
1
Dt
ln(D
t
)
= b lim
t
A(D
t
)
1
Dt
ln(D
t
)
= 0
for any positive . Thus, by Propsition 4.6, agent B becomes extinct as long as the
risk aversion coecient satises (19). According to the the same proposition, if the
risk aversion coecient satises (20), then then agent B survives.
A.12 Proof of Propositions 5.1 and 5.2
As we show in corollary 4.2, there is no survival in models with bounded relative risk
aversion. Thus, w
t
converges to zero almost surely. Consider now the rst term in
(10). By the mean value theorem and the bound given in the proposition, this term
equals
A(x

t+s
)D
t+s
w
t+s
C
D
t+s
w
t+s
x

t+s
,
for some x

t+s
[(1 w
t+s
)D
t+s
, D
t+s
]. Since, almost surely, the ratio
D
t+s
x
t+s

converges
to one, w
t+s
converges to zero, and the relative risk aversion coecient (x

t+s
) is
bounded, we conclude that the rst term in (10) converges to zero. The same ar-
gument implies that the second term converges to zero almost surely, and therefore
39
there is no price impact. This proves Proposition 5.1. Proposition 5.2 follows from
the fact that bounding the endowment implies bounding relative risk aversion.
A.13 Proof of Proposition 5.3
We use the tighter of the two upper bounds on the consumption share w
t
of agent B
in Proposition 4.4:

_
Dt
Dt(1wt)
A(x) dx

C |ln(1 w
t
)| C

ln
_
1 + (
t
)
1/C
_

C (
t
)
1/C
.
Then,
|PI(t, s;

= 0)| =

_
D
t+s
D
t+s
(1w
t+s
)
A(x) dx
_
Dt
Dt(1wt)
A(x) dx

_
D
t+s
D
t+s
(1w
t+s
)
A(x) dx

_
Dt
Dt(1wt)
A(x) dx

C
_
(
t
)
1/C
+ (
t+s
)
1/C
_
(A7)
A.14 Proof of Proposition 5.4
Consider t large enough, so that
t
< 1, and therefore w
t
1/2. Because aggregate
endowment is bounded, D D
t
D,

_
Dt
Dt(1wt)
A(x) dx

_
sup
x[D/2,D]
A(x)
_
w
t
D (A8)
and therefore
|PI(t, s;

= 0)| =

_
D
t+s
D
t+s
(1w
t+s
)
A(x) dx
_
Dt
Dt(1wt)
A(x) dx

_
D
t+s
D
t+s
(1w
t+s
)
A(x) dx

_
Dt
Dt(1wt)
A(x) dx

_
sup
x[D/2,D]
A(x)
_
D(w
t
+ w
t+s
) (A9)
40
A.15 Proof of Propositions 5.5, 5.6, and 5.7
Since the utility function is of DARA type, condition (7) implies that
| ln(
t
)| A((1 w
t
)D
t
)D
t
(1 2w
t
) (A10)
and therefore, using condition (21), lim
t
w
t
= 1/2. Thus, agent B survives. This
proves Proposition 5.5.
Continuing, condition (6) and lim
t

t
= 0 a.s. imply that there exists a T so
that for t > T, we have w
t

1
2
a.s. We will consider in this proof such times t > T.
Finally, recall that while A(x) is decreasing, the conditions of the theorem imply
A(x)x is increasing in x.
Next, to show that there is price impact, we verify that the dierence
PI(t, s;

= 1)
_
D
t+s
(1w
t+s
)
1
2
D
t+s
A(x) dx
_
Dt(1wt)
1
2
Dt
A(x) dx
does not converge to zero almost surely. This corresponds to

= 1 in the denition
of price impact.
First, the upper bound: DARA and condition (7) imply that
_
D(1w)
1
2
D
A(x) dx
1
2
_
D(1w)
Dw
A(x) dx =
1
2
| ln()|
Second, the lower bound. A preliminary from (A10):
| ln()| A(D) D(1 2w) A
_
D
2
_
D
_
1
2
w
_
implies
0
_
1
2
w
_
2
A
_
D
2
_
D
|ln ()|
2
A
_
D
2
_
D
0 a.s. (A11)
41
Next, since A(x)x is increasing, a Taylor expansion shows that
_
D(1w)
1
2
D
A(x) dx
_
D(1w)
1
2
D
A
_
D
2
_
D
2
1
x
dx (A12)
A
_
D
2
_
D
2
ln
_
1 + 2
_
1
2
w
__
A
_
D
2
_
D
2
_
2
_
1
2
w
_

2
_
1 + 2
_
1
2
w

__
2
_
1
2
w
_
2
_
where w

_
w,
1
2

. However, (A11) implies that the last term in the third line of
(A12) approaches zero almost surely as t approaches , and so
_
D(1w)
1
2
D
A(x) dx A
_
D
2
_
D
_
1
2
w
_
+ o(t) (A13)
Next, another Taylor expansion shows that
| ln() | =
_
D(1w)
Dw
A(x) dx A
_
D
2
__
1
2
w
_
D +
_ D
2
Dw
A
_
D
2
_
D
2
1
x
dx (A14)
A
_
D
2
_
D
_
1
2
w
_
A
_
D
2
_
D
2
ln
_
1 2
_
1
2
w
__
A
_
D
2
_
D
_
1
2
w
_
A
_
D
2
_
D
_

_
1
2
w
_

1
_
1 2
_
1
2
w

__
2
_
1
2
w
_
2
_
where w

_
w,
1
2

. However, (A11) implies that the last term in the third line of
(A14) approaches zero almost surely as t approaches , and so
| ln() | 2A
_
D
2
_
D
_
1
2
w
_
+ o(t) (A15)
We combine (A13) and (A15) to obtain the lower bound
_
D(1w)
1
2
D
A(x) dx
1
2
| ln()| + o(t)
42
We thus impose bounds on price impact:
PI(t, s;

= 1)
1
2
(ln(
t+s
) ln(
t
)) +o(t) (A16)
PI(t, s;

= 1)
1
2
(ln(
t+s
) ln(
t
)) +o(t) (A17)
We conclude that there is an asymptotic dierence in stochastic discount factors
between the original economy and the benchmark economy with

= 1 if and only
if the increments of ln(
t
) do not vanish. Moreover, asymptotically, the stochastic
discount factor does not depend on (or

). This shows that it is impossible to nd

a value of

that would eliminate the dierences between the state-price density in

our economy and the benchmark. This proves Proposition 5.6.
Proposition 5.7 follows by setting
t
1.
A.16 Example of the Impact of Distorted Beliefs on Prices
of Non-Primitive Claims
Consider a discrete-time economy with log-utility preferences, time-preference param-
eter , and the aggregate endowment given by D
t
. Assume that agent A has correct
beliefs, and agent Bs beliefs are distorted, with the density equal to
t
. Assume that

t
0 as t (see Section refsec:examples for the discussion of this condition on
beliefs). Let the utility weight of agent B be one.
According to Corollary 4.2, agent B fails to survive in the long run. Moreover,
according to Proposition 5.1, agent B has no long-run price impact on the Arrow-
Debreu prices in this economy.
Consider a long-lived, non-primitive state-contingent claim H, with the cash ow
stream given by D
H
t
= 1
[t1]
. Note that the payo of H is a function of the underlying
state space, and hence is dened without an explicit connection to agent B.
In an economy without belief distortions, the state-price density is
t
= exp(t)D
1
t
,
and hence the price of asset H is
P
H,hom
t
= D
t
E
t
_

t+1
e
(st)
D
1
s
1
[s1]
_
.
43
In the economy with heterogeneous beliefs,

t
= e
t
1 +
t
D
t
,
and the price of H is
P
H,het
t
= D
t
(1 +
t
)
1
E
t
_

t+1
e
(st)
D
1
s
(1 +
s
) 1
[s1]
_
.
Since
P
H,het
t
P
H,hom
t

2
1 +
s
,
and
t
0, P-a.s., we conclude that the price of asset H is aected, in the long run,
by the distorted beliefs of agent B. The reason for price impact of Bs beliefs on asset
H is that the payo of H is concentrated on a set of states in which agent B has
a nontrivial consumption share. This set of states has an asymptotically vanishing
probability but is relevant for the pricing of long-lived non-primitive state-contingent
claims.
44
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