Beauty Contest was the metaphor used by John Maynard Keynes in his famous 1936 work, The General Theory of Employment, Interest, and Money, to describe prices of assets in the market. Kaynes likes investment choices to a contest in a newspaper that shows 100 pictures, and the reader needs to choose six prettiest faces. The winner is the one whose preference matches the popular choice of the overall competitors.
Levels of thinking
How will a player play this game? One approach is to assign six random photos and hope it somehow connects with the average choice. It is zero-level thinking. The first-level thinker selects the pictures she likes. The rational player knows that it is not those she likes that win prizes but the ones the others like (second-level thinking). So she wants to pick what she thinks the others would select. If you go one level up, you choose the one that others think is others’ choice.
We have seen a similar contest in an earlier post describing Richard Thaler’s experiment in the Financial Times (1997). The competition was to choose a number between 0 to 100, and the person whose choice is two-thirds of the average guess gets the prize. A first-level thinker assumes that others pick numbers at random. The average of such a collection is 50, and 2/3 of 50 is 33. The second leveller knows the other participants are rational first-levellers and would guess 33. So she will choose 2/3 x 33 = 22. Following this iterative reasoning, one will end up at the Nash Equilibrium, which is zero!
The prices
In this viewpoint, Keynes hypothesises that the market prices stocks not based on their fundamentals but on what the participants (buyers and sellers) decide.
References
Keynes, John Maynard (1936). The General Theory of Employment, Interest and Money
Keynes’s ‘beauty contest’: FT
Results from experiments
Keynesian beauty contest: Wiki
