Randomness and the Madness of Crowds

Abstract

Human interaction often appears to be random and at times even chaotic. We use game theory, the mathematical study of interactive decision making, to explain the role of rationality and randomness in strategic behavior. In many of these situations, humans deliberately create randomness as a best response and equilibrium strategy. Moreover, once out of equilibrium, individual beliefs about the real intentions of others introduce significant randomness into otherwise quite simple and deterministic situations of interaction. In a second step we discuss the role of randomness on financial markets, which are prototypical institutions for the aggregation of individual behavior. As in certain simple games, financial markets can produce outcomes that are close to perfect randomness. In fact, random walks in financial returns are considered by most scholars to be efficient and desirable. Finally, we apply game theoretical insights to behavior on financial markets and show how strategic speculation on ‘greater fools’ can create a ‘madness of crowds’ that often ends in chaotic swings, bubbles and crashes.