We develop a structural theory of beliefs and behavior, that relaxes the assumption of time-consistency in beliefs. Our theory is based on the trade-off between optimism, which raises anticipatory utility, and objectivity, which promotes efficient actions. We present it in the context of allocating work on a project over time, develop testable implications to contrast it with models assuming time-inconsistent preferences, and compare its predictions to existing evidence on behavior and beliefs. Our predictions are: (i) optimal beliefs are optimistic and time-inconsistent; (ii) people optimally exhibit the planning fallacy; (iii) incentives for rapid task completion make beliefs more optimistic and worsen work smoothing, while incentives for accurate duration prediction make beliefs less optimistic and improve work smoothing; (iv) without a commitment device, beliefs become less optimistic over time; (v) in the presence of a commitment device, beliefs may become more optimistic over time, and people optimally exhibit preference for commitment.
This paper proposes a welfare criterion for economies in which agents have heterogeneously distorted beliefs. Instead of taking a stand on whose belief is correct, our criterion asserts an allocation to be belief-neutral inefficient if it is inefficient under any convex combination of agents' beliefs. While this criterion gives an incomplete ranking of social allocations, it can identify negative-sum speculation in a broad range of prominent models with distorted beliefs.
People tend to underestimate the work involved in completing tasks and consequently finish tasks later than expected or do an inordinate amount of work right before projects are due. We present a theory in which people underpredict and procrastinate because the ex-ante utility benefits of anticipating that a task will be easy to complete outweigh the average ex-post costs of poor planning. We show that, given a commitment device, people self-impose deadlines that are binding but require less smoothing of work than those chosen by a person with objective beliefs. We test our theory using extant experimental evidence on differences in expectations and behavior. We find that reported beliefs and behavior generally respond as our theory predicts. For example, monetary incentives for accurate prediction ameliorate the planning fallacy while incentives for rapid completion aggravate it.
A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account the fact that inflation lowers future real mortgage costs. We decompose the price-rent ratio into a rational component-meant to capture the "proxy effect" and risk premia–and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time series variation of the mispricing, and that the tilt effect is very unlikely to rationalize this finding.
Brunnermeier, Markus K, and Jonathan A Parker. “Optimal Expectations”. The American Economic Review 95 (2005): , 95, 1092-1118. Print.Abstract
Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they are optimistic. This paper studies utility-based biases in beliefs by supposing that beliefs maximize average felicity, optimally balancing this benefit of optimism against the costs of worse decision making. A small optimistic bias in beliefs typically leads to first-order gains in anticipatory utility and only second-order costs in realized outcomes. In a portfolio choice example, investors overestimate their return and exhibit a preference for skewness; in general equilibrium, investors' prior beliefs are endogenously heterogeneous. In a consumption-saving example, consumers are both overconfident and over optimistic.
This paper provides a theoretical rationale for three experimental results of Prospect Theory: risk preferences are over gains and losses, loss aversion, and diminishing sensitivity. We consider a (boundedly rational) decision maker who does not find her new optimal consumption bundle with certainty when she is faced with a new income level. This alters her indirect utility function and makes her more risk averse at her current reference income level and less risk averse for a range of incomes below her reference income level.