Overconfidence and Speculative Bubbles

Posted: 3 Oct 2003

See all articles by José Scheinkman

José Scheinkman

Columbia University; Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

Wei Xiong

Princeton University - Department of Economics; National Bureau of Economic Research (NBER)

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Abstract

Motivated by the behavior of asset prices, trading volume and price volatility during episodes of asset-price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset buyer acquires an option to sell the asset to other agents when those agents have more optimistic beliefs. As in Harrison and Kreps (1978), agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, bubbles are accompanied by large trading volume and high price volatility. Our analysis shows that while Tobin's tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility.

Suggested Citation

Scheinkman, José and Xiong, Wei, Overconfidence and Speculative Bubbles. Journal of Political Economy, Vol. 111, December 2003. Available at SSRN: https://ssrn.com/abstract=444380

José Scheinkman

Columbia University ( email )

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Princeton University - Department of Economics ( email )

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National Bureau of Economic Research (NBER)

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Wei Xiong (Contact Author)

Princeton University - Department of Economics ( email )

Princeton, NJ 08544-1021
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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