Testing Models of Belief Bias: An Experiment

Optimistic beliefs affect important areas of economic decision making, yet direct knowledge on how belief biases operate remains limited. To better understand these biases I conduct an experiment examining beliefs about binary events with financial stakes. By varying financial prizes in outcomes, as well as incentive payments for accuracy, the experiment is able to distinguish between two leading theories of optimistic belief formation that differ in their assumptions about how such beliefs are constrained. The Optimal Expectations theory of Brunnermeier and Parker (2005) models beliefs as being constrained through the future costs of holding incorrect beliefs, while the Affective Decision Making model of Bracha and Brown (2012) argues that beliefs are constrained by mental costs of distorting reality. The results suggest that people hold optimistically biased beliefs, and comparative statics indicate that these beliefs are not constrained by increasing the costs of making inaccurate judgments. In fact, the results support the theory of Bracha and Brown (2012), as observed bias is increasing in the size of incentive payments for accuracy.