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.
Entrants' profits, number of entrants.
There is more entry and lower industry profit when people are betting on their own relative skill rather than on a random device. Random-rank: industry profit is positive in 77% of rounds, and total profit is only negative in 6% of rounds. Average industry profit across rounds is $16.87. Skill-rank: Industry profit is strictly positive in only 40% of rounds, and negative in 42% of rounds. Average profit across the skill-rank rounds is -$1.56.