Do Markets Correct Biases in Probability Judgment? Evidence from Market Experiments

Abstract

In this chapter, two studies are reported which test whether simple biases in the probability judgment of individuals affect their aggregate behavior in markets. A judgment bias is a systematic error, which does not cancel out when individual judgments are aggregated. Trading in a market is one of many tasks used to study individual decision making. The natural hypothesis is that biases which have been found using other tasks will also affect individual judgment in a market setting. However, to economists the market 'task' is special: Economists think irrationality is generally erased by the forces of market discipline (or at least, market prices are not determined by the actions of irrational people). Since judgment biases are irrational, economists therefore conclude that these biases will not affect market outcomes. Their argument deserves a closer examination.