Myopia, Time-Inconsistency, Survival and Bankruptcy in Financial Markets

What is the characterization of asset prices and investor’s behavior under myopic or time-inconsistent preferences? This paper investigates the characterization of financial market equilibrium when individuals are myopic or time-inconsistent. We consider an infinite horizon economy under certainty with two heterogeneous CRRA individuals, one good and one long-lived asset. The question of survival in the market arises when individuals are time-inconsistent or myopic with wrong expectations about equilibrium asset prices. We provide sufficient conditions such that the individual with intertemporal elasticity of substitution (IES) close or equal to one, log-utility, dominates the market and the other individual with IES further away from one is eliminated. In the long-run, only the individual with IES close or equal to one has an impact on asset prices. Thus, long-run asset prices reflect only the preference parameters of the surviving individual. On the other hand, asset prices are characterized by extreme dynamics if the economy is populated by myopic individuals only, who have perfect foresight about equilibrium asset prices. We show that even though the dividends of the long-lived asset are constant over time, there exist asset price dynamics that resemble an everexpanding asset price bubble. Lastly, we introduce debt in the initial set-up by allowing individuals to hold liquid and illiquid assets. This allows for the possibility of bankruptcies. ∗I am indebted to Herakles Polemarchakis and Andres Carvajal for their guidance and support throughout my studies. I have benefited from discussions with Pablo Beker which has made many interesting suggestions.