IMPERFECT COMPETITION AND THE SUBOPTIMALITY OF RATIONAL-EXPECTATIONS

This paper investigates whether 'nonrational' expectations can lead to outcomes which, other things being equal, Pareto dominate rational ex pectations outcomes. In order to carry out this investigation we const ruct an intertemporal micro-based macroeconomic model with the two fol lowing strong points: (a) It accommodates both rational and non-ration al expectations. (b) Both prices and quantities are determined by opti mizing agents. In particular prices are determined by explicit price s etters using objective demand curves. In this model the first theorem of welfare holds, so that the Walrasian equilibrium with rational expe ctations cannot be Pareto dominated. This conclusion is extremely frag ile, however, and we show that as soon as some degree of imperfect com petition is present, rational expectations are suboptimal, in the sens e that they are dominated by 'irrational expectations'.