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Optimal Expectations

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  • Jonathan A. Parker
  • Markus K. Brunnermeier

Abstract

This 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 Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Winter Meetings with number 426.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nawm04:426

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Keywords: expectations formation; beliefs; overconfidence;

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  1. 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.
  2. Akerlof, George A & Dickens, William T, 1982. "The Economic Consequences of Cognitive Dissonance," American Economic Review, American Economic Association, American Economic Association, vol. 72(3), pages 307-19, June.
  3. Caplin, Andrew & Leahy, John, 1997. "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.
  4. Roland BĂ©nabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(3), pages 871-915, August.
  5. 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.
  6. 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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