AbstractThis paper introduces a tractable, structural model of subjective beliefs. Since agents that plan for the future care about expected future utility flows, current felicity can be increased by believing that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decision making, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the total well-being of an agent over time. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return of their investment and underdiversify. In general equilibrium, agents' prior beliefs are endogenously heterogeneous, leading to gambling. Second, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life. Third, in choosing when to undertake a single task with an uncertain cost, agents exhibit several features of procrastination, including regret, intertemporal preference reversal, and a greater readiness to accept commitment.
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Bibliographic InfoPaper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 426.
Date of creation: 11 Aug 2004
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expectations formation; beliefs; overconfidence;
Other versions of this item:
- Markus K. Brunnermeier & Jonathan A. Parker, 2005. "Optimal Expectations," American Economic Review, American Economic Association, American Economic Association, vol. 95(4), pages 1092-1118, September.
- Markus K. Brunnermeier & Jonathan A. Parker, 2004. "Optimal Expectations," NBER Working Papers 10707, National Bureau of Economic Research, Inc.
- Brunnermeier, Markus K & Parker, Jonathan A, 2004. "Optimal Expectation," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4656, C.E.P.R. Discussion Papers.
- Markus K. Brunnermeier & Jonathan A. Parker, 2002. "Optimal Expectations," Working Papers, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics. 146, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
- Jonathan Parker & Markus K Brunnermeier, 2002. "Optimal Expectations," FMG Discussion Papers, Financial Markets Group dp434, Financial Markets Group.
- Markus K. Brunnermeier & Jonathan A. Parker, 2002. "Optimal expectations," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 24954, London School of Economics and Political Science, LSE Library.
- D1 - Microeconomics - - Household Behavior
- D8 - Microeconomics - - Information, Knowledge, and Uncertainty
- E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
- G1 - Financial Economics - - General Financial Markets
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- Barsky, Robert B, et al, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(2), pages 537-79, May.
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"Psychological Expected Utility Theory and Anticipatory Feelings,"
Working Papers, C.V. Starr Center for Applied Economics, New York University
97-37, C.V. Starr Center for Applied Economics, New York University.
- Andrew Caplin & John Leahy, 2001. "Psychological Expected Utility Theory And Anticipatory Feelings," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 116(1), pages 55-79, February.
- Roland Bénabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(3), pages 871-915, August.
- Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1995. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
- Leeat Yariv, 2002. "I'll See It When I Believe It - A Simple Model of Cognitive Consistency," Cowles Foundation Discussion Papers, Cowles Foundation for Research in Economics, Yale University 1352, Cowles Foundation for Research in Economics, Yale University.
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