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Higher-order Beliefs in Simple Trading Models

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  • Timothy Shields

    ()
    (Argyros School of Business and Economics, Chapman University, USA)

  • Baohua Xin

    ()
    (Rotman School of Management, University of Toronto, Canada)

Abstract

We examine the role of higher order beliefs in asset markets where coordination between a buyer and seller can lead to gains to trade. The scenarios are modeled such that trader’s strategies do not only depend upon their beliefs of underlying economic phenomena, but also upon the others’ beliefs regarding the beliefs of themselves. Under certain parameters the breakdown of coordination is predicted–even when both traders are certain the underlying phenomena dictates trade is advantageous. We demonstrate the equilibrium predictions can be constructed via a small number of iterated thought exercises. The experimental design allows us to control for various behavioral phenomena and examine subjects’ decisions across different accounting regimes as to tease out strategic uncertainty due solely to information asymmetry. In this setting we find evidence supporting higher order beliefs. An implication is that the lack of uniformity leads to lack of common knowledge of the beliefs of others, which in turn leads to the spreading of inefficient outcomes.

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Bibliographic Info

Paper provided by Chapman University, Economic Science Institute in its series Working Papers with number 12-18.

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Length: 40 pages
Date of creation: 2012
Date of revision:
Handle: RePEc:chu:wpaper:12-18

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Related research

Keywords: information asymmetry; experiment; strategic uncertainty; higher-order beliefs; iterative reasoning;

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