  This paper consists of two parts. In the first part, we develop a new
information theory, in which it is not a coincidence that information and
physical entropy share the same mathematical formula. It is an adaptation of
mind to help search for resources. We then show that psychological patterns
either reflect the constraints of physical laws or are evolutionary adaptations
to efficiently process information and to increase the chance of survival in
the environment of our evolutionary past. In the second part, we demonstrate
that the new information theory provides the foundation to understand market
behavior. One fundamental result from the information theory is that
information is costly. In general, information with higher value is more
costly. Another fundamental result from the information theory is that the
amount of information one can receive is the amount of information generated
minus equivocation. The level of equivocation, which is the measure of
information asymmetry, is determined by the correlation between the source of
information and the receiver of information. In general, how much information
one can receive depends on the background knowledge of the receiver. The
difference in cost different investors are willing to pay for information and
the difference in background knowledge about a particular information causes
the heterogeneity in information processing by the investment public, which is
the main reason of the price and volume patterns observed in the market. Many
assumptions in some of the recent models on behavioral finance can be derived
naturally from this theory.
