Self-organized criticality in a herd behavior model of financial markets

This paper explains the fat-tail distribution of asset transaction volumes and prices by a model of rational herd behavior of traders. Each trader decides whether to buy an asset by observing private information and other traders’ actions. A trader’s buying action reveals his positive private information and affects the other traders’ beliefs in favor of buying, leading to strategic complementarity. A power-law distribution emerges for the number of buying actions in a static Nash equilibrium. This model provides an economic reason as to why the stock market has to exhibit a criticality in the connectivity of the traders’ actions. I am benefited by comments from the seminar participants at University of Tokyo and the Econophysics Colloquium 2006 at International Christian University, the editors of the special issue, and particularly an anonymous referee.