Keynesian Beauty Contest - Overview

Overview

Keynes described the action of rational agents in a market using an analogy based on a fictional newspaper contest, in which entrants are asked to choose from a set of six photographs of women that are the "most beautiful." Those who picked the most popular face are then eligible for a prize.

A naïve strategy would be to choose the face that, in the opinion of the entrant, is the most beautiful. A more sophisticated contest entrant, wishing to maximize the chances of winning a prize, would think about what the majority perception of beauty is, and then make a selection based on some inference from his knowledge of public perceptions. This can be carried one step further to take into account the fact that other entrants would each have their own opinion of what public perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each level attempting to predict the eventual outcome of the process based on the reasoning of other rational agents.

“It is not a case of choosing those that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment Interest and Money, 1936).

Keynes believed that similar behavior was at work within the stock market. This would have people pricing shares not based on what they think their fundamental value is, but rather on what they think everyone else thinks their value is, or what everybody else would predict the average assessment of value to be.

National Public Radio's Planet Money tested the theory by having its listeners select the cutest of three animal videos. The listeners were broken into two groups. One selected the animal they thought was cutest, and the other selected the one they thought most participants would think was the cutest. The results showed significant differences between the groups. Fifty percent of the first group selected a video with a kitten, compared to seventy-six percent of the second selecting the same video. Individuals in the second group were generally able to disregard their own preferences and accurately make a decision based on the preferences of others. The results were considered to be consistent with Keynes's theory.

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