Moreover, agents influence one another indirectly. The choices they make have a direct effect on prices - Which in turn affects the choices of others. As an engineer would say, there is strong feedback at work. Whereas traditional models assume that agents adopt their (rational) strategies in response to an externally imposed evolution of prices, in reality the agents help to make those prices as well as responding to them.
Here again there is the danger of caricaturing the way that economists think. As John Kay points out, " The idea that behaviour of participants in markets is influenced by what happens in markets" has been explored in "literally thousands of books and articles written by economists." What physics has to offer microeconomic modelling is new insights into the factors that control the markets, but new tools with which to accommodate them. Physicists have been dealing with systems of many interacting particles for over a century. It would be foolish to assume that these tools can necessarily be translated directly into economic terms. But equally, it would be surprising if some of the phenomena already well understood in physics should not turn up in some form in economics.
The man who first introduced interactions into microeconomics was mathematician familiar with both physics and economics theory. In 1974, Hans Follmer of the University of Bonn in Germany concocted an "interacting -agents" model of the economy which was based on the principles of the Ising model of magnets. As we have seen, in the simplified description of a magnetic material the magnetic atoms all sit on a regular grid, and they "make choices": they align their spins either in one direction or in the opposite direction. These choices are interdependent: the alignment of each atom depends on those of its neighbours, since their magnetic fields exert forces on one another. In Follmer's model, each atom represent an agent faced with choices about how to trade. The same idea is now widely applied by economists and econophysicists who, like Alan Kirman, are seeking to extend traditional microeconomics by using interacting-agents models. The predictions of these models depends on the rules that govern the interaction. Follmer found that his model generated more than one stable state - more than macroeconomic landscape - just as the Ising model offers two magnetically aligned states. This was already food for thought for economists weaned on the idea that market has a particular, unique equilibrium....
...In the 1980s Robert Shiller considered how herding behaviour might influence market dynamics in a quantitative way. He was interested in what controls the moment-to-moment variations in the volatility clustering, in which big fluctuations come in bursts separated by relatively quiescent periods. During the bursts, the market is very active. It seems possible that these are the result of herding behaviour, which prompts increasing numbers of traders into frantic buying or selling. But there remains the underlying question: where do the fluctuations come from?
Well to know more about it, you can look to buy the book "Critical Mass - how one thing leads to another"
- Evidence from Portuguese Mutual Funds -
Abstract
We test for herding by Portuguese mutual funds over the period of 1998 to 2000. We
employ the (herding) measure of trading suggested by Lakonishok et al. (1992). We
find strong evidence of herding behavior for Portuguese mutual funds. Furthermore, our
results suggest that the level of herding is 4 to 5 times stronger than the herding found
for institutional investors in mature markets. The herding effect seems to affect, as
likely, purchases and sales of stocks. There seems to be a stronger tendency to herd
among medium-cap funds rather than very large or very small funds, and among funds
with less stocks. Lastly, herding seems to decrease when the stock market is doing well
or is more volatile.
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