Higher-Order Beliefs in Trading Markets: Experimental Evidence

• In Event: Disclosures in Decision Making

Abstract

This paper experimentally investigates the role of higher-order beliefs in asset markets. We use a setting where a buyer and a seller have potentially differential information about the value of an asset, and derive equilibrium predictions that trade is expected to occur when traders base their trading behavior only on their own beliefs of the fundamental uncertainty, while higher-order iterative reasoning of beliefs prevents such trade to occur. Our experimen- tal design allows us to control for various behavioral phenomena and examine participants’ decisions across different accounting regimes as to isolate the effect of strategic uncertainty on trading. We find evidence consistent with the participants’ limited use of higher-order beliefs that give rise to contagious spreading of inefficient outcomes. Nonetheless, we find that not only the information, but also the shared understanding of the information, matters economically in promoting efficiency. These results offer insight into whether more uniform measurement rules and/or more disaggregated accounting disclosure should be desired.

Authors

• Timothy W Shields, Chapman University

• Baohua Xin, University of Toronto