Working Paper: NBER ID: w10707
Authors: Markus K. Brunnermeier; Jonathan A. Parker
Abstract: This paper introduces a tractable, structural model of subjective beliefs. Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they believe that better outcomes are more likely. On the other hand, biased expectations lead to poorer decisions and worse realized outcomes on average. Optimal expectations balance these forces by maximizing average felicity. A small bias in beliefs typically leads to first-order gains due to increased anticipatory utility and only to second-order costs due to distorted behavior. We show that in a portfolio choice problem, agents overestimate the return on their investment and exhibit a preference for skewness. In general equilibrium, agents' prior beliefs are endogenously heterogeneous. Finally, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic.
Keywords: No keywords provided
JEL Codes: D1; D8; E21; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Biased beliefs (D91) | Overestimation of returns on investments (G17) |
| Overestimation of returns on investments (G17) | Increased consumption and lower savings (E21) |
| Biased beliefs (D91) | Increased consumption and lower savings (E21) |
| Biased expectations (D84) | Poorer decision-making outcomes (D91) |
| Optimistic biases in beliefs (D80) | Overconsume and under-save (E21) |
| Distorted perceptions of probabilities (D80) | Misaligned expectations and behaviors (D84) |