preprints.org > social sciences > behavior sciences > doi: 10.20944/preprints202401.1826.v1

Preprint Article Version 1 Preserved in Portico This version is not peer-reviewed

Version 1 : Received: 25 January 2024 / Approved: 25 January 2024 / Online: 25 January 2024 (10:43:06 CET)
Version 2 : Received: 28 March 2024 / Approved: 29 March 2024 / Online: 29 March 2024 (17:05:47 CET)
Version 3 : Received: 3 April 2024 / Approved: 3 April 2024 / Online: 4 April 2024 (17:37:48 CEST)

In this paper, we consider an economy, in which consumers exhibit unrealistic optimism, and show that such an economy is more likely to undergo early recessions and underinvestment rather than experiencing bubbles or overinvestment. In this model, each consumer incorrectly believes that a negative aggregate preference shock will hit all other consumers, but not herself. When consumers have such an unrealistic optimism, the output price must fall prematurely before the aggregate shock occurs. The reason is that if the price does not plummet today, all consumers would postpone making purchases by falsely expecting that an arbitrage opportunity will arise in the future when the aggregate shock hits the economy, in which case, the output market cannot clear. We also show that the government has the potential to improve welfare of the economy by providing subsidies, if the government judiciously selects the right timing for intervention.

unrealistic optimism; recessions; market collapse; government intervention

Social Sciences, Behavior Sciences

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