Overconfidence and Excess Entry: An Experimental Approach

Psychological studies show that most people are overconfident about their own relative abilities, and unreasonably optimistic about their futures. This study explores whether optimistic biases could plausibly and predictably influence economic behavior in one particular setting - entry into competitive games or markets. Many empirical studies show that most new businesses fail within a few years. Some possible explanations for the high rate of business failure are reviewed. The hypothesis that business failure is a result of managers acting on the optimism about relative skill they exhibit in surveys is considered. The findings are consistent with the prediction that overconfidence leads to excessive business entry.

Policy implications

Individuals may prefer performance based incentives schemes more often than standard theory predicts, regardless of their skill-level compared to their competitors.

Additional information

Hypotheses/research question

Do optimistic biases influence economic behaviour in the setting of entry into competitive games or markets? Hypothesis: managers acting on the optimism about relative skill they exhibit is a significant contributor to the number of business failures, as it leads to business entry mistakes.

Study design

Laboratory experiment

Subjects were undergraduates and M.B.A.'s at the University of Chicago and The Wharton School of business. They were recruited either using standard recruiting instructions or "self-selection" instructions where subjects were asked if they would like to volunteer for an experiment in which performance on sports or current events trivia would determine their payoff, and people who were very good might earn a considerable sum of money. Subjects were seated in a large classroom where they were explained the two types of ranking systems and were informed that there would be two sequences of 12 rounds for each ranking condition. Subjects were informed that the decisions they made for one of the rounds, chosen randomly, would determine their payoff.

Cost benefit ratio

Not available.

Rounds of data collection

3: Baseline (recruiting) + Results (number of entrants and payoffs during each round of the game) + Skill assessment (puzzles or trivia)

Baseline data collection and method

First, subjects were recruited by either standard recruiting or "self-selection", and volunteers provided basic demographic data.

Data collection method and data collected

Subjects were administered a comprehension test to guarantee the understanding of the payoff table of the game, and the games were played. For each game, entry decisions and payoffs were recorded. At the end of the experimental session, subjects either solved puzzles or took the trivia quiz, and their skill rank was determined.

Unit of analysis

Market entrants

Stratification

Reference

Camerer, C., & Lovallo, D., 1999. 'Overconfidence and Excess Entry: An Experimental Approach'. American Economic Review, pages 306-318.

Overconfidence and Excess Entry: An Experimental Approach

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