Does Competition Reduce Forecasting Bias?

Abstract:     
Psychologists and behavioral economists have documented numerous deviations from the rational expectations model of forecasting that is a common assumption of neoclassical economics. In response, it has been claimed that, while such biases may exist for individuals, firms that exhibit (costly) biases will be eradicated through competitive pressures. In this paper, I test this hypothesis directly, by examining the effects of competition on the biases of firms' sales forecasts. Using data from firm-level surveys in five African countries, I show that firms that are protected from foreign competition generate 'backward-looking' forecasts of sales growth. There is no such deviation from rational expectations among firms in markets with foreign competitors. I further provide evidence that these erroneous forecasts have real effects on these firms' inventory management.

Number of Pages in PDF File: 27

Keywords: Forecasting, Rational Expectations, Market Structure, Foreign Competition

JEL Classification: D21, D84

working papers series