A battle of informed traders and the market game foundations for rational expectations equilibrium

Potential manipulation of prices and convergence to rational expectations equilibrium is studied in a game without noise traders. Informed players with initially long and short positions (bulls and bears) seek to manipulate consumer expectations in opposite directions. In equilibrium, period 1 prices reveal the state, so manipulation is unsuccessful. Bears and uninformed consumers sell up to their short-sale limits in period 1. Bulls buy in period 1 but receive arbitrage losses. When the number of bulls and bears approaches infinity, the equilibrium converges to the REE. Without short-sale constraints there is a non-revealing equilibrium but no revealing equilibrium. ∗This paper developed out of a research project with Rich McLean and Andy Postlewaite, to whom I am extremely grateful. An associate editor, a referee, and Yaron Azrieli provided valuable comments, and I had useful discussions with PJ Healy and Roberto Serrano. I bear sole responsibility for mistakes, however.