Evolutionary Selection of Expectations in Positive and Negative Feedback Markets

An economic environment is a feedback system, where the dynamics of aggregate variables depend on individual expectations and vice versa. The type of feedback mechanism is crucial for the aggregate outcome. Experiments with human subjects (Heemeijer, Hommes, Sonnemans, and Tuinstra, 2009) have shown that price converges to the fundamental level in a negative feedback environment but fails to do so under positive feedback. We present an explanation of these experimental results by means of a model of evolutionary switching between heuristics. Active heuristics are chosen endogenously, on the basis of their past performance. Under negative feedback an adaptive heuristic dominates explaining fast price convergence, whereas under positive feedback a trend-following heuristic dominates resulting in persistent price deviations and oscillations. JEL codes: D03, G12, D84, C91, C92.