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 under diversify. 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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Paper provided by Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics. in its series Working Papers with number
146.
Markus K. Brunnermeier & Jonathan A. Parker, 2005.
"Optimal Expectations,"
American Economic Review,
American Economic Association, vol. 95(4), pages 1092-1118, September.
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Paper
Markus K. Brunnermeier & Jonathan A. Parker, 2004.
"Optimal Expectations,"
NBER Working Papers
10707, National Bureau of Economic Research, Inc.
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