Overconfidence, subjective perception and pricing behavior

Abstract

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: i) overconfident firms are less inclined to acquire information relative to the rational benchmark; ii) prices might exhibit excess volatility driven by non-fundamental noise. We explore the empirical predictions of our model for idiosyncratic price volatility.