Microeconomics Workshop - Gilat Levy
Mon, 03/13/2017 - 4:15pm
London School of Economics
498 Uris Hall
We suggest a framework to analyse how individuals combine multiple sources of information to form predictions. We assume that individuals understand each source of information separately, but they are not certain about the correlation between them. We bound the ability of individuals to grasp such correlations by a notion of "correlation capacity". We show that given this capacity there is a set of predictions which is completely characterised by two parameters: the correlation capacity parameter and the naive combination of forecasts which ignores correlation. The analysis yields two countervailing effects on behaviour. A higher correlation capacity creates more uncertainty and therefore possibly conservative behaviour. On the other hand, when the naive combination is relatively precise, it can induce risky behaviour. We show how this trade-off affects behaviour in different applications, including financial investments and CDO ratings. Specifically we show that complex assets are likely to lead to complete neglect of correlation by individuals.
Event Categories: Microeconomic Theory