Finite-Order Beliefs and Welfare-Enhancing Instruments in the Centipede Game
29 Pages Posted: 31 May 2007
Date Written: May 2007
This paper investigates the effectiveness of two instruments designed to defer termination in the centipede game: an insurance against termination by the opponent, and an option to offer the opponent a bonus for not terminating the game. The rational prediction in both cases is passing until close to the end. Empirically, however, only the bonus option is used by the subjects. The results indicate that subjects readily understand the bonus as a reasonable price for permanent passing by their opponent. Yet, they fail to realise what the insurance signals about the insured player, namely that passing until close to the end is a dominant strategy for this player. A simple behavioural model based on finite order beliefs is shown to be largely consistent with these findings.
Keywords: Centipede Game, Cooperation, Finite-Order Beliefs
JEL Classification: C91, D61
Suggested Citation: Suggested Citation