Firm Dynamics with Subjective Beliefs

A key question regarding firms' performance is how their perceptions and beliefs about the future impact their behavior. I use novel data on US firms' subjective beliefs to study whether they exhibit overoptimism (i.e. their expectations exceed rational forecasts) and overconfidence (i.e. they underestimate the variance across potential outcomes) in their perceptions of future sales growth. I document that US firms are overoptimistic, overestimating future sales growth by 2 to 5 percentage points, and also overconfident, underestimating the uncertainty about future sales by about 70 percent. I then study the quantitative implications of distorted subjective beliefs in a model of firm dynamics with investment subject to rich adjustment costs, and calibrate the model to match the degree of overconfidence and overoptimism observed in the data. Overoptimistic firms in the model expect better conditions in the future, leading them to have lower exit rates and lower profitability on average; by contrast, overconfident firms perceive less uncertainty about the future, leading them to exit quickly in the face of bad shocks and to grow disproportionately large in the face of good ones. Preliminary quantitative results also suggest that overconfidence rather than overoptimism is the more significant of the two distortions in terms of its effects on firm dynamics.