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Behavior, Production and Competition

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Author Info

  • Just, David R.
  • Zilberman, David

Abstract

Previous 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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File URL: http://purl.umn.edu/127075
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Bibliographic Info

Paper provided by Cornell University, Department of Applied Economics and Management in its series Working Papers with number 127075.

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Date of creation: 2005
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Handle: RePEc:ags:cudawp:127075

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Related research

Keywords: Institutional and Behavioral Economics; Production Economics;

References

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  1. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  2. Chew, Soo Hong, 1983. "A Generalization of the Quasilinear Mean with Applications to the Measurement of Income Inequality and Decision Theory Resolving the Allais Paradox," Econometrica, Econometric Society, vol. 51(4), pages 1065-92, July.
  3. Viscusi, W Kip, 1989. " Prospective Reference Theory: Toward an Explanation of the Paradoxes," Journal of Risk and Uncertainty, Springer, vol. 2(3), pages 235-63, September.
  4. Palich, Leslie E. & Ray Bagby, D., 1995. "Using cognitive theory to explain entrepreneurial risk-taking: Challenging conventional wisdom," Journal of Business Venturing, Elsevier, vol. 10(6), pages 425-438, November.
  5. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  6. Hey, John D & Orme, Chris, 1994. "Investigating Generalizations of Expected Utility Theory Using Experimental Data," Econometrica, Econometric Society, vol. 62(6), pages 1291-1326, November.
  7. Dan Lovallo & Colin Camerer, 1999. "Overconfidence and Excess Entry: An Experimental Approach," American Economic Review, American Economic Association, vol. 89(1), pages 306-318, March.
  8. Just, David R. & Peterson, Hikaru Hanawa, 2003. "Expected Utility Calibration for Continuous Distributions," Working Papers 127170, Cornell University, Department of Applied Economics and Management.
  9. Blake, David, 1996. "Efficiency, Risk Aversion and Portfolio Insurance: An Analysis of Financial Asset Portfolios Held by Investors in the United Kingdom," Economic Journal, Royal Economic Society, vol. 106(438), pages 1175-92, September.
  10. Sandmo, Agnar, 1971. "On the Theory of the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 61(1), pages 65-73, March.
  11. David R. Just & Hikaru Hanawa Peterson, 2003. "Diminishing Marginal Utility of Wealth and Calibration of Risk in Agriculture," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 85(5), pages 1234-1241.
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