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Optimal Expectations

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Author Info
Markus K. Brunnermeier
Jonathan A. Parker

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Abstract

This paper introduces a tractable, structural model of subjective beliefs. Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they believe that better outcomes are more likely. On the other hand, biased expectations lead to poorer decisions and worse realized outcomes on average. Optimal expectations balance these forces by maximizing average felicity. A small bias in beliefs typically leads to first-order gains due to increased anticipatory utility and only to second-order costs due to distorted behavior. We show that in a portfolio choice problem, agents overestimate the return on their investment and exhibit a preference for skewness. In general equilibrium, agents' prior beliefs are endogenously heterogeneous. Finally, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10707.

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Date of creation: Aug 2004
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Handle: RePEc:nbr:nberwo:10707

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Find related papers by JEL classification:
D1 - Microeconomics - - Household Behavior
D8 - Microeconomics - - Information, Knowledge, and Uncertainty

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References listed on IDEAS
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.:
  1. 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. [Downloadable!] (restricted)
  2. 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.
  3. 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. [Downloadable!] (restricted)
  4. Roland Bénabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 871-915, August. [Downloadable!] (restricted)
  5. 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. [Downloadable!] (restricted)
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  6. Leeat Yariv, 2002. "I'll See It When I Believe It - A Simple Model of Cognitive Consistency," Cowles Foundation Discussion Papers 1352, Cowles Foundation, Yale University. [Downloadable!]
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