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

Listed author(s):
  • Anna Conte

    ()

    (University of Westminster)

  • Peter G. Moffatt

    ()

    (School of Economics, University of East Anglia)

  • Fabrizio Botti

    ()

    (Department of Social, Economic, Actuarial and Demographic Studies, Sapienza University of Rome)

  • Daniela T. Di Cagno

    ()

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

  • Carlo D'Ippoliti

    ()

    (Department of Social, Economic, Actuarial and Demographic Studies, Sapienza University of Rome)

Data on contestantsÕ choices in Italian Game Show Affari Tuoi are analysed in a way that separates the effect of risk attitude (preferences) from that of beliefs concerning the amount of money that will be offered to contestants in future rounds. The most important issue addressed in the paper is what belief function is actually being used by contestants. The parameters of this function are estimated freely along with the parameters of a choice model. 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 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.

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Paper provided by Dipartimento di Economia e Finanza, LUISS Guido Carli in its series Quaderni DEF with number 161.

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Date of creation: Jan 2009
Handle: RePEc:lui:wpaper:161
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