A sunspot equilibrium is a market equilibrium in which prices depend on otherwise irrelevant random variable. The name is inspired by a theory of nineteenth century economist William Jevons that sunspots affected the stock market. (The theory, while wrong, isn’t quite as rediculous as it sounds. Jevons thought, by looking at the data he had on sunspots and agricultural prices, that he detected a pattern that indicated that sunspots caused crops to fail, which in turn caused recessions.)
A sunspot equilibrium would then be a self-fulfilling prophecy. If everyone expected that sunspots caused recessions, that in principle could be sufficient to cause a recession, even if the cause-and-effect existed entirely in people’s heads. Note that this outcome, while not optimal, would still be individually rational: even if you knew that sunspots didn’t really cause recessions, you would know that everyone else was expecting a recession, so you would act accordingly.
Karl Shell, one of the inventors of the concept, has a list of links to his papers on sunspot equilibria. In particular, he links to a short survey article he co-authored with Bruce Smith.
The British economist, John Maynard Keynes, once remarked that most people think of a stock market as a beauty contest where the objective was to choose the prettiest girl. In fact, he said, the real objective is to choose the girl which the other judges were going to choose as the prettiest. (JMK, of course, lived in less language-sensitive times.)
This, essentially, is why it is possible to use the minority game (or the El Farol Bar Problem) to successfully model financial markets. See wikipedia entries:
http://en.wikipedia.org/wiki/Minority_game
http://en.wikipedia.org/wiki/El_Farol_bar_problem
And see also the publications of the Oxford Centre for Computational Finance, especially those of Neil Johnson.
http://www.occf.ox.ac.uk/
Sunspot equilibria are rational expectations equilibria, so that basically everyone knows what everyone else’s expectations are, yet everyone still acts as if prices depend on the sunspot (which make prices depend on the sunspot).
I am minority game skeptic. Everything I’ve ever seen seems to indicate that the main purpose of the model is to allow physicists to treat investors like they are little molecules in an ideal gas. It’s a long way from Keynes.
Well, everyone knowing everyone else’s expectations is also a long way from reality. One of the problems of rational expectations theory (and neo-classical economics more generally) is its assumption that all economic actors, although they may differ in their preferences over outcomes, are identical in that they all have access to the same information, which they all receive at the same time, and that they each reason about (process) this information identically.