Less Rationality, More Efficiency: a Laboratory Experiment on “Lemon”
Less Rationality, More Efficiency: a Laboratory Experiment on “Lemon” Markets.y Roland Kirstein¤ Annette Kirstein¤¤ Center for the Study of Law and Economics Discussion Paper 2004-02 Abstract We have experimentally tested a theory of bounded rational behav- ior in a “lemon market”. It provides an explanation for the observation that real world players successfully conclude transactions when perfect rationality predicts a market collapse. We analyzed two different market designs: complete and partial market collapse. Our empirical observations deviate substantially from these theoretical predictions. In both markets, the participants traded more than theoretically predicted. Thus, the ac- tual outcome is closer to efficiency than the theoretical prediction. Even after 20 repetitions of the first market constellation, the number of trans- actions did not drop to zero. Our bounded rationality approach to explain these observations starts with the insight that perfect rationality would require the players to per- form an infinite number of iterative reasoning steps. Bounded rational players, however, carry out only a limited number of such iterations. We have determined the iteration type of the players independently from their market behavior. A significant correlation exists between iteration types and observed price offers. JEL classification: D8 , C7, B4 Encyclopedia of Law and Economics: 0710, 5110 Keywords: guessing games, beauty contests, market failure, adverse selection, lemon problem, regulatory failure, paternalistic regulation yWe are grateful to Max Albert, George Akerlof, Ted Bergstrom, Friedel Bolle, Ralf Fried- mann, Rod Garrat, Hans Gerhard, Wolfgang Kerber, Manfred K¨onigstein,G¨oranSkogh, Dieter Schmidtchen, Jean-Robert Tyran and other seminar and conference participants in Hamburg, Karlsruhe, Kassel, Saarbruecken, Santa Barbara and Zurich for valuable comments (the usual disclaimer applies).
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