Belief Distortions

Brunnermeier, Markus K, Alp Simsek, and Wei Xiong. “A Welfare Criterion for Models with Biased Beliefs”. Quarterly Journal of Economics 129.4 (2014): , 129, 4, 1711-1752. Print.Abstract

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.

Welfare Biased Beliefs Slides.pdf Welfare Biased Beliefs.pdf
Brunnermeier, Markus K, Filippos Papakonstantinou, and Jonathan A Parker. “An Economic Model of the Planning Fallacy”. 2008: n. pag. Print.Abstract

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.

planning_fallacy.pdf planning_fallacy_slides.pdf
Brunnermeier, Markus K, and Christian Julliard. “Money Illusion and Housing Frenzies”. The Review of Financial Studies 21 (2008): , 21, 135-180. Print.Abstract

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.

money_illusion_housing_frenzies.pdf slides.pdf

The confusion between changes in nominal and real interest rates boosts real house prices when inflation declines.

Brunnermeier, Markus K, Christian Gollier, and Jonathan A Parker. “Optimal Beliefs, Asset Prices, and the Preference for Skewed Returns”. The American Economic Review 97 (2007): , 97, 159-165. Print.Abstract



Different households overinvest in different positively skewed assets, making portfolio returns idiosyncratically skewed and lowering returns on these skewed assets.

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.

optimal_expectations.pdf optimal_expectations_slides.pdf

A structural model of "optimal" belief distortions due to anticipatory utility.