We study mislearning from equilibrium prices, and contrast this with mislearning from exogenous fundamentals. We micro-found mislearning from prices with a psychologically founded theory of “Partial Equilibrium Thinking” (PET), where traders learn fundamental information from prices, but fail to realize others do so too. PET leads to over-reaction, and upward sloping demand curves, thus contributing to more inelastic markets. The degree of individual-level over-reaction and the extent of inelasticity vary with the composition of traders, and with the informativeness of new information. More generally, unlike mislearning from fundamentals, mislearning from prices (i) generates a two-way feedback between prices and beliefs that can provide an arbitrarily large amount of amplification and (ii) can rationalize both over-reaction and more inelastic markets. The two classes of biases are not mutually exclusive. Instead, they interact in very natural ways, and mislearning from prices can vastly amplify mislearning from fundamentals.

We develop a dynamic theory of “Partial Equilibrium Thinking” (PET), which micro-founds time-varying return extrapolation: extrapolative beliefs are present at all times, but only sometimes manifest themselves in explosive ways. We formalize the distinction between normal times shocks and “displacement shocks,” and study their interaction with extrapolative beliefs. In normal times, PET generates constant extrapolation and momentum. After a displacement shock that increases uncertainty, PET leads to stronger and time-varying extrapolation, triggering bubbles and endogenous crashes. Our theory sheds light on both market dynamics in normal times and Kindleberger’s narrative of bubbles within a unified framework.