Overconfidence, Subjective Perception, and Pricing Behavior

Pierpaolo Benigno and Anastasios G. Karantounias

Working Paper 2017-14
November 2017

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We study the implications of overconfidence for price setting in a monopolistic competition setup with incomplete information. Our price-setters overestimate their abilities to infer aggregate shocks from private signals. The fraction of uninformed firms is endogenous; firms can obtain information by paying a fixed cost. We find two results: (1) overconfident firms are less inclined to acquire information, and (2) prices might exhibit excess volatility driven by nonfundamental noise. We explore the empirical predictions of our model for idiosyncratic price volatility.

JEL classification: D4;D8;E3

Key words: overconfidence, imperfect common knowledge, information acquisition, inflation volatility

The authors are grateful to Giuseppe Moscarini, Ricardo Reis, and Michael Woodford for useful discussions and comments. They also thank seminar participants at Columbia University, the Board of Governors of the Federal Reserve, and New York University and conference participants at the New York Area Monetary Policy Workshop. The views expressed here are the authors' and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors' responsibility.
Please address questions regarding content to Pierpaolo Benigno, LUISS Guido Carli and Einaudi Institute of Economics and Finance, Viale Romania 32, 00197 Roma, Italy, pbenigno@luiss.it, or Anastasios Karantounias, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street NE, Atlanta, GA 30309, anastasios.karantounias@atl.frb.org.
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