An Experiment on Forward versus Backward Induction: How Fairness and Levels of Reasoning Matter
We report the experimental results on a game with an outside option where induction contradicts with background induction based on a focal, risk dominant equilibrium. The latter procedure yields the equilibrium selected by Harsanyi and Selton's (1888) theory, which is hence here in contradiction with strategic stability (Kohlberg-Mertens (1985)). We find the Harsanyi-Selton solution to be in much better agreement with our data. Since fairness and bounded rationality seem to matter we discuss whether recent behavioral theories, in particular fairness theories and learning, might explain our findings. The fairness theories by Fehr and Schmidt (1999), Bolton and Ockenfels (2000), when calibrated using experimental data on dictator- and ultimatum games, indeed predict that forward induction should play no role for our experiment and that the outside option should be chosen by all sufficiently selfish players. However, there is a multiplicity of "fairness equilibra", some of which seem to be rejected because they require too many levels of reasoning"
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