Higher-order Beliefs in Simple Trading Models

Timothy Shields and Baohua Xin ()
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Baohua Xin: Rotman School of Management, University of Toronto, Canada

Working Papers from Chapman University, Economic Science Institute

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.

Keywords: information asymmetry; experiment; strategic uncertainty; higher-order beliefs; iterative reasoning (search for similar items in EconPapers)
Pages: 40 pages
Date: 2012
New Economics Papers: this item is included in nep-exp and nep-gth
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:chu:wpaper:12-18

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