BEHAVIORAL ECONOMICS

The Shleifer Model

Deciphering Shleifer
Players

Profitabili
ty of
Players

Equilibriu
m

Assets
Decipheri
ng
Shleifer

Behavior

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Example: Safe asset versus unsafe asset

Imagine an economy with two assets (financial assets)

Safe asset, s
Unsafe asset, u
Assume a single consumption good
Safe asset, s
Suppose that s is always convertible (back and forth
between the consumption good and itself)
That means the price of s is always 1 in terms of the
consumption good
It is called the safe asset its price is always 1,
regardless of anything
Unsafe asset, u
Suppose that u is not convertible back and forth into the
consumption good
You buy u on the open market and sell it on the open
market
That means that the price of u is not fixed
It is called the unsafe asset because the price of u is not
fixed
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Example: Safe asset versus unsafe asset

(contd)

Now imagine both s and u pay the same dividend, d

d is constant, period after period

d is paid with complete certainty, no uncertainty at all

This implies that neither s or u have fundamental risk

If someone gave you 10 units of s and you never sold it,

your outcome would be the same as if someone gave you
10 units of u

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The Players

Arbitrageur
s

Noise
Traders

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Utility Functions
Expected Utility, not Expected Value
U = -e-(2)w

Utility

Wealth

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Overlapping Generations Structure

All agents live two periods
Born in period 1 and buy a portfolio (s, u)
Live (and die) in period 2 and consume
At time t
The (t-1) generation is in period 2 of their life
The (t) generation is in period 1 of their life
So, they overlap

t1

t2

t3

t4

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How many are arbitrageurs? How many are

noise traders?
0

Total number of traders is the same as the

number of real numbers between zero and one an infinite number
Measure means the size of any interval
Examples
The measure of the interval between 0
and is
The measure of a single point (a single
number) is zero
The measure of the interval between zero
and one is 1
Think of it as a fraction of the entire interval
Measure of noise traders is and measure of
arbitrage traders is 1 - . That is, the fraction of 8

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What is a noise trader?

Pt+1 is the price of the risky asset at

time t+1
t+1 is the mean misperception of
pt+!

t+!

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What is an arbitrage trader?

Arbitrage traders correctly perceive the
true distribution of pt+1
There is systematic error in estimation
of future price, pt+1
But, arbitrageurs face risk unrelated to the
true distribution of pt+1
If there were no noise traders, then there
would be no variance in the price of the risky
assetbut, there are noise traders, hence the
risky asset is a risky asset

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Arbitrageur versus Traders

Arbitrageurs expectations are

correct; noise traders expectations
are biased Difference is
t+1

Correct mean of pt+1

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The Main Issue

What happens in equilibrium

Undetermined
Some forces make pt > 1, some
forces push pt < 1, result is
indeterminant
Who makes more profit, arbitrageurs or
noise traders?
Depends
But, it is perfectly possible for
arbitrageurs to make more!
Survival?
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When Do Noise Traders Profit More Than

Arbitrageurs?
Noise traders can earn more than
arbitrageurs when * is positive
Meaning when noise traders are
systematically too optimistic
Why?
Because they have relatively more of the
risky asset than the arbitrageurs
But, if * is too large, noise traders will
not earn more than arbitrageurs
The more risk averse everyone is (higher
in the utility function), the wider the
range of values of for which noise
traders do better than arbitrageurs
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What Does Shleifer Accomplish?

Given two assets that are fundamentally
identical, he shows a logic where the market fails
to price them identically
Assumes systematic noise trader activity
Shows conditions that lead to noise traders
actually profiting from their noise trading
Shows why arbitrageurs could have trouble
(even when there is no fundamental risk)

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