Decision Making and Trade Without Probabilities

Abstract

This paper studies trade in a first-price sealed bid auction where agents know only a range of possible payoffs. The setting is one in which a winner’s curse arises, so that if agents have common risk preferences and common priors, then expected utility theory leads to a prediction of no trade. In contrast, we develop a model of rational non-probabilistic decision making, under which trade can occur because not bidding is a weakly dominated strategy. We use a laboratory experiment to test the predictions of both models, and also of models of expected utility with heterogeneous priors and risk preferences. We find strong support for the rational non-probabilistic model.

Keywords: Knightian uncertainty, ambiguity, price formation, auctions

JEL Classification: D80, D82, D83