JOURNAL OF ECONOMIC THEORY 58, 9-40 (1992) Evolution and Market Behavior* LAWRENCE BLUME AND DAVID EASLEY Department of Economics, Cornell Unll'ersay, Ithaca, Nell' York 14850 ReceIved February 21, 1992; revised Apnl 15, 1992 In a conventional asset market model we study the evolutionary process generated by wealth flows between investors. Asymptotic behaVIor of our model IS completely determined by the Investors' expected growth rates of wealth share. Investment rules are more or less "fit" depending upon the value of thIS expectation, and more fit rules survive In the market at the expense of the less fit. Using thIS cnterion we examine the long run behaVIOr of asset pnces and the common behef that the market selects for ratIOnal Investors. We find that fit rules need not be ratIOnal, and ratIOnal rules not be fit. Finally, we investIgate how the market selects over various adaptIve deCIsion rules Journal of Economic LlIerature ClassificatIOn N urn bers: 090, 080. "1992 AcademiC Press. Inc 1. INTRODUCTION In this paper we delineate in a conventional asset market model the evolutionary processes which determine the long run behavior of the market. Evolutionary ideas such as natural selection and adaptive behavior have a long history in economic analysis. Two streams of literature have had a significant impact on contemporary economic thought. First are those writings on economic dynamics that hinge on the success or failure of risk-taking entrepreneurs. This view of economic progress is recognizable in both Knight [22] and Schumpeter [27]. A part of this literature are the writings of Alchian [1], of Friedman [17] in his famous essay "On the Methodology of Positive Economics," and of other writers in the early 1950s who attempt to explain why procedural rationality has predictive power. Their answer is an appeal to natural selection which we call the "market selection hypothesis." Market forces favor the survival of economic actors whose decisions are most nearly optimal. According to Friedman [17, p. 21], " ... firms behave as if they were seeking to maximize their expected returns ... " He reasons [17, p. 22] that "unless the behavior * Support from NSF Grant SES-8921415 and the Center for Analytic Economics at Cornell Umversity is gratefully acknowledged. 9 0022-0531/92 $5.00 Copynght e 1992 by AcademiC Press, Inc All nghts of reproductIOn In any fonn reserved