Iterative Reasoning in an Experimental "Lemons" Market

Abstract

In this paper we experimentally test a theory of boundedly rational behavior in a "lemons" market. We analyze two different market designs, for which perfect rationality implies complete and partial market collapse, respectively. Our empirical observations deviate substantially from the predictions of rational choice theory: Even after 20 repetitions, the actual outcome is closer to efficiency than expected. We examine to which extent the theory of iterated reasoning contributes to the explanation of these observations. Perfectly rational behavior requires a player to perform an infinite number of iterative reasoning steps. Boundedly 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 the iteration types and the observed price offers.