Was Bayes Overconfident? An Experiment on Belief Updating

Abstract

Behavioral economics has now been used to explain almost any observed deviation from rationality. One prominent example is systematic agent overconfidence, which has been used to explain general market phenomena, such as excess entry into markets and volatility in asset markets. This study takes a step back from the burgeoning literature on overconfidence to explore the economic underpinnings of systemic agent overconfidence. Using a simple lab experiment that is tightly linked to theory, we find that the extant empirical evidence commonly interpreted as irrational overconfidence is consonant with the rational Bayesian model. Mirror experimental treatments exploring underconfidence reveal similar insights. Our results suggest that had the literature started with a different set of experiments—a mirror of those typically utilized—then the rational model would be attacked because people would argue that agents are systematically underconfident. We suspect that economic phenomena such as underinvestment in education and general labor market immobility would then be prime targets for this behavioral explanation.

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