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, inter-temporal preference reversal, and a greater readiness to accept commitment.
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Bibliographic InfoPaper provided by London School of Economics and Political Science, LSE Library in its series LSE Research Online Documents on Economics with number 24954.
Length: 49 pages
Date of creation: Dec 2002
Date of revision:
Expectation formation; Beliefs; Overconfidence; Wishful thinking; Procrastination; Gambling;
Other versions of this item:
- Markus K. Brunnermeier & Jonathan A. Parker, 2004. "Optimal Expectations," NBER Working Papers 10707, National Bureau of Economic Research, Inc.
- Jonathan A. Parker & Markus K. Brunnermeier, 2004. "Optimal Expectations," Econometric Society 2004 North American Winter Meetings 426, Econometric Society.
- Jonathan Parker & Markus K Brunnermeier, 2002. "Optimal Expectations," FMG Discussion Papers dp434, Financial Markets Group.
- Brunnermeier, Markus K & Parker, Jonathan A, 2004. "Optimal Expectation," CEPR Discussion Papers 4656, C.E.P.R. Discussion Papers.
- Markus K. Brunnermeier & Jonathan A. Parker, 2002. "Optimal Expectations," Working Papers 146, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- D1 - Microeconomics - - Household Behavior
- D8 - Microeconomics - - Information, Knowledge, and Uncertainty
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Andrew Caplin & John Leahy, 2001. "Psychological Expected Utility Theory And Anticipatory Feelings," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 55-79, February.
- Akerlof, George A & Dickens, William T, 1982. "The Economic Consequences of Cognitive Dissonance," American Economic Review, American Economic Association, vol. 72(3), pages 307-19, June.
- Roland Bénabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 871-915, August.
- 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, vol. 112(2), pages 537-79, May.
- Leeat Yariv, 2002. "I'll See It When I Believe It - A Simple Model of Cognitive Consistency," Cowles Foundation Discussion Papers 1352, Cowles Foundation for Research in Economics, Yale University.
- Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
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