When Higher Productivity Hurts: The Interaction Between Overconfidence and Capital

Abstract

We investigate how overconfidence and production technology interact to influence decision making. We show that increasing a production factor can make an overconfident agent worse off. Two effects drive this result. First, if the production factor is a complement with ability, then the overconfident agent may overpay for the production factor. Second, acquiring the factor will increase excess entry into activities that are productivity dependent. In contrast, if the factor is a substitute with ability, the agent will undervalue the factor even though it may reduce excess entry. In a laboratory experiment we find that subjects overpay for ability-complements, and underpay for ability-substitutes, as predicted. Subjects provided with ability-complements earn less due to increased excess entry. In the context of investing, our findings suggest that human capital, if it is a complement with ability, will lead an overconfident investor to switch from a passive investment strategy to a lower-return active strategy.

Keywords: overconfidence, ability-complements, ability-substitutes, excess entry

JEL Classification: C91, D03, D24