Rationally Misplaced Confidence

University of Arizona Working Paper 18-05

41 Pages Posted: 13 Mar 2018 Last revised: 10 Nov 2021

See all articles by Derek Lemoine

Derek Lemoine

University of Arizona - Department of Economics

Date Written: October 7, 2021

Abstract

I show that persistent underconfidence and overconfidence arise from rational Bayesian learning when effort and ability are complementary and payoffs are affected by a general class of shocks. Which arises depends on the decision-making environment. If greater effort either reduces or does not affect the variance of outcomes, then agents become underconfident on average, but if greater effort increases that variance by enough, then agents become overconfident on average. The mechanism is that agents learn away overconfidence and underconfidence at asymmetric rates because (i) Bayesian updating requires that their sensitivity to new information depend on their effort choices and (ii) their optimized effort choices depend on beliefs about their own ability. As one implication, management can induce overconfidence in employees by providing feedback that is conditionally vague.

Keywords: learning, effort, confidence, ability, talent, feedback, appraisals

JEL Classification: D83, G41, M54

Suggested Citation

Lemoine, Derek, Rationally Misplaced Confidence (October 7, 2021). University of Arizona Working Paper 18-05, Available at SSRN: https://ssrn.com/abstract=3138936 or http://dx.doi.org/10.2139/ssrn.3138936

Derek Lemoine (Contact Author)

University of Arizona - Department of Economics ( email )

McClelland Hall
Tucson, AZ 85721-0108
United States

HOME PAGE: http://www.dereklemoine.com/

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