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A Test of the Rational Expectations Hypothesis using data from a Natural Experiment

Listed author(s):
  • Anna Conte

    ()

    (Department of Economic and Business Sciences, LUISS Guido Carli)

  • Peter G. Moffatt

    ()

    (School of Economics, University of East Anglia)

  • Fabrizio Botti

    ()

    (Department of Economic and Business Sciences, LUISS Guido Carli)

  • Daniela Di Cagno

    ()

    (Department of Economic and Business Sciences, LUISS Guido Carli)

  • Carlo D'Ippoliti

    ()

    (Department of Economic and Business Sciences, LUISS Guido Carli)

Data on contestantsÕ choices in Italian Game Show Affari Tuoi are analysed in a way that separates the effect of risk attitude from that of beliefs concerning the amount of money that will be offered to contestants in future rounds. The importance of belief-formation is confirmed by the estimation of a mixture model which establishes that the vast majority of contestants are forward-looking as opposed to myopic. The most important issue addressed in the paper is what belief function is actually being used by contestants. This function is estimated in an unconstrained way as a component of the choice model, which is estimated using maximum simulated likelihood. Separate identification of the belief function and preferences is possible by virtue of the fact that at a certain stage of the game, beliefs are not relevant, and risk attitude is the sole determinant of choice. The rational expectations hypothesis is tested by comparing the estimated belief function with the ÒtrueÓ offer function which is estimated using data on offers actually made to contestants. We find that there is a significant difference between these two functions, and hence we reject the rational expectations hypothesis. However, when a simpler Òrule-of-thumbÓ structure is assumed for the belief function, we find a correspondence to the function obtained from data on actual offers. Our overall conclusion is that contestants are rational to the extent that they make use of all available relevant information, but are not fully rational because they are not processing the information in an optimal way. The importance of allowing the choice data to convey the belief function without prejudice is emphasised.

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Paper provided by Dipartimento di Economia e Finanza, LUISS Guido Carli in its series Quaderni DEF with number 146.

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Date of creation: Aug 2007
Handle: RePEc:lui:wpaper:146
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