Behavior, Production and Competition
AbstractPrevious studies have found underestimation of risk, or overconfidence, to be a key factor in entrepreneurship. We use a simple model of competitive equilibrium to show that an irrational under-estimation of risk provides a competitive advantage leading to a greater chance of survival under competitive pressures. Overconfidence leads to greater investment, production levels, average profit and greater variance of profits. Despite the greater variance of profits, if enough producers under-estimate their risk, they should collectively drive more rational decision-makers form the market. We illustrate a local equivalency between Kahneman and Tversky’s prospect theory model, and a subjective expected utility model with decision-makers display overconfidence. This model allows us to characterize risk attitudes through two primary effects: diminishing marginal utility of wealth (rational), and diminishing distance perception (behavioral). Diminishing distance perception is a simple measure of misperception of risk. Results from economic simulations suggest that diminishing distance perception may be a more important determinant of market behavior, and entrepreneurial success, than diminishing marginal utility of wealth.
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Bibliographic InfoPaper provided by Cornell University, Department of Applied Economics and Management in its series Working Papers with number 127075.
Date of creation: 2005
Date of revision:
Institutional and Behavioral Economics; Production Economics;
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"Prospect Theory: An Analysis of Decision under Risk,"
Levine's Working Paper Archive
7656, David K. Levine.
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