Limited higher order belieft and the welfare effects of public information

Abstract

In games with strategic complementarities, public information about the state of the world has a larger impact on equilibrium actions than private information of the same precision, because the former is more informative about the likely behavior of others. This may lead to welfare-reducing ‘overreactions’ to public signals as shown by Morris and Shin (2002). Recent experiments on games with strategic complementarities show that subjects attach a lower weight to public signals than theoretically predicted. Aggregate behavior can be better explained by a cognitive hierarchy model where subjects employ limited levels of reasoning. This paper analyzes the welfare effects of public information under limited levels of reasoning and argues that for strategies according with experimental evidence, public information that is more precise than private information cannot reduce welfare, unless the policy maker has instruments that are perfect substitutes to private actions.