Testing Psychological Forward Induction in the Lost Wallet Game

This paper tests Psychological Forward Induction in the Lost Wallet Game, in an attempt to explain an empirical puzzle observed by Dufwenberg & Gneezy (2000) that the size of the outside option forgone by the first mover does not affect the behavior of the second mover. This is puzzling as Psychological Forward Induction and other theories predict that raising the outside option will increase the reward provided by the second mover to the first mover for foregoing the outside option. Our experiment tests whether the second movers update their beliefs after observing their paired first movers’ decision by eliciting beliefs with different second mover knowledge of first mover decision, depending on treatment. We find that second movers do update their beliefs conditional on receiving information on the first mover’s action, supporting Psychological Forward Induction.