The concept of adaptively rational equilibrium (A.R.E.) is introduced. Agents adapt their beliefs over time by choosing from a finite set of different predictor or expectations functions. Each predictor is a function of past observations and has a performance or fitness measure which is publicly available. Agents make a rational choice concerning the predictors based upon their past performance. This results in a dynamics across predictor choice which is coupled to the equilibrium dynamics of the endogenous variables. As a simple, but typical, example we consider a cobweb type demand-supply model where agents can choose between rational and naive expectations. In an unstable market with (small) positive information costs for rational expectations, a high intensity of choice to switch predictors leads to highly irregular equilibrium prices converging to a strange attractor. The irregularity of the equilibrium time paths is explained by the existence of a so-called homoclinic orbit and its associated complicated dynamical phenomena. Thus local instability and global complicated dynamics may be a feature of a fully rational notion of equilibrium.

We investigate expectation formation in a controlled experimental environment. Subjects are asked to predict the price in a standard asset pricing model. They do not have knowledge of the underlying market equilibrium equations, but they know all past realized prices and their own predictions. Aggregate demand for the risky asset depends upon the forecasts of the participants. The realized price is then obtained from market equilibrium with feedback from six individual expectations. Realized prices differ significantly from fundamental values and typically exhibit oscillations around, or slow convergence to, this fundamental. In all groups participants coordinate on a common prediction strategy.