Standard models in economics stress the role of intelligent agents who maximize utility. However, there may be situations where constraints imposed by market institutions dominate strategic agent behavior. We use data from the London Stock Exchange to test a simple model in which minimally intelligent agents place orders to trade at random. The model treats the statistical mechanics of order placement, price formation, and the accumulation of revealed supply and demand within the context of the continuous double auction and yields simple laws relating order-arrival rates to statistical properties of the market. We test the validity of these laws in explaining cross-sectional variation for 11 stocks. The model explains 96% of the variance of the gap between the best buying and selling prices (the spread) and 76% of the variance of the price diffusion rate, with only one free parameter. We also study the market impact function, describing the response of quoted prices to the arrival of new orders. The nondimensional coordinates dictated by the model approximately collapse data from different stocks onto a single curve. This work is important from a practical point of view, because it demonstrates the existence of simple laws relating prices to order flows and, in a broader context, suggests there are circumstances where the strategic behavior of agents may be dominated by other considerations. double auction market ͉ market microstructure ͉ agent-based models T he traditional paradigm in economics is one of rational utility maximizing agents. Recognizing limitations in human cognition, economists have increasingly explored models in which agents have bounded rationality. We take this direction even further here by testing a model of trading in financial markets that drops agent rationality almost altogether. These results are particularly striking because the model predicts simple quantitative laws relating different properties of markets that are borne out well when tested against data.Although no one would dispute that agents in financial markets behave strategically, and that for some purposes taking this into account is essential, we show in this paper that there are some problems where other factors may be more important. Previous work along these lines includes that of Becker (1), who showed that random agent behavior and budget constraint are sufficient to guarantee the proper slope of supply and demand curves, and Gode and Sunder (2), who demonstrated that if one replaces the students in a standard classroom economics experiment by zero-intelligence agents with a budget constraint, they perform surprisingly well. More specifically, the model we test here builds on earlier work on the double auction in financial economics (3-6) and physics (7-11). [See also interesting subsequent work (12, 13).] The model makes the simple assumption that agents place orders to buy or sell at random (14, 15), subject to constraints imposed by current prices. Although one might argue that tracking prices requires at least som...

Standard models in economics stress the role of intelligent agents who maximize utility. However, there may be situations where constraints imposed by market institutions dominate strategic agent behavior. We use data from the London Stock Exchange to test a simple model in which minimally intelligent agents place orders to trade at random. The model treats the statistical mechanics of order placement, price formation, and the accumulation of revealed supply and demand within the context of the continuous double auction and yields simple laws relating order-arrival rates to statistical properties of the market. We test the validity of these laws in explaining cross-sectional variation for 11 stocks. The model explains 96% of the variance of the gap between the best buying and selling prices (the spread) and 76% of the variance of the price diffusion rate, with only one free parameter. We also study the market impact function, describing the response of quoted prices to the arrival of new orders. The nondimensional coordinates dictated by the model approximately collapse data from different stocks onto a single curve. This work is important from a practical point of view, because it demonstrates the existence of simple laws relating prices to order flows and, in a broader context, suggests there are circumstances where the strategic behavior of agents may be dominated by other considerations. double auction market ͉ market microstructure ͉ agent-based models T he traditional paradigm in economics is one of rational utility maximizing agents. Recognizing limitations in human cognition, economists have increasingly explored models in which agents have bounded rationality. We take this direction even further here by testing a model of trading in financial markets that drops agent rationality almost altogether. These results are particularly striking because the model predicts simple quantitative laws relating different properties of markets that are borne out well when tested against data.Although no one would dispute that agents in financial markets behave strategically, and that for some purposes taking this into account is essential, we show in this paper that there are some problems where other factors may be more important. Previous work along these lines includes that of Becker (1), who showed that random agent behavior and budget constraint are sufficient to guarantee the proper slope of supply and demand curves, and Gode and Sunder (2), who demonstrated that if one replaces the students in a standard classroom economics experiment by zero-intelligence agents with a budget constraint, they perform surprisingly well. More specifically, the model we test here builds on earlier work on the double auction in financial economics (3-6) and physics (7-11). [See also interesting subsequent work (12, 13).] The model makes the simple assumption that agents place orders to buy or sell at random (14, 15), subject to constraints imposed by current prices. Although one might argue that tracking prices requires at least som...

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