The Cushioning Benefits of Biased Beliefs

45 Pages Posted: 12 Sep 2017 Last revised: 20 Jul 2018

See all articles by Lawrence J. Jin

Lawrence J. Jin

California Institute of Technology

Matthew Shum

California Institute of Technology

Mali Zhang

California Institute of Technology - Division of the Humanities and Social Sciences

Date Written: November 18, 2017

Abstract

We present a model of dynamic investment and production in which producers may have biased beliefs in which they overextrapolate recent demand conditions into the future. This bias leads producers' beliefs to exhibit insufficient mean reversion, as these producers underestimate the degree of mean reversion in the demand process. In a volatile industry, while biased beliefs lead firms to make sub-optimal investment decisions in the short-run, they can be beneficial in the long-run by counteracting the general trend in the industry, "cushioning" the industry against prolonged downturns and aiding faster recovery. As an empirical case study, we consider oil exploration in Alaska. We present evidence that firms in this industry were subject to extrapolation bias, leading to drilling of lower-profit wells after recent price increases. Calibration of our model to Alaska oil exploration shows that the cushioning effect can be large: in a typical episode of oil price decline arising from a sequence of adverse demand shocks, the cushioning effect reduces the decline of the oil price by 8.2% and accelerates the price recovery by 27%. This showcases the potential positive implications that biased beliefs can have on industry dynamics.

Keywords: cushioning, extrapolation, oil exploration

JEL Classification: G02, G12, G30

Suggested Citation

Jin, Lawrence J. and Shum, Matthew and Zhang, Mali, The Cushioning Benefits of Biased Beliefs (November 18, 2017). Available at SSRN: https://ssrn.com/abstract=3034749 or http://dx.doi.org/10.2139/ssrn.3034749

Lawrence J. Jin (Contact Author)

California Institute of Technology ( email )

1200 E. California Blvd.
MC 228-77
Pasadena, CA 91125
United States
626-395-4558 (Phone)

HOME PAGE: http://www.hss.caltech.edu/content/lawrence-jin

Matthew Shum

California Institute of Technology ( email )

Pasadena, CA 91125
United States

Mali Zhang

California Institute of Technology - Division of the Humanities and Social Sciences ( email )

1200 East California Blvd.
Pasadena, CA 91125
United States

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