Optimism and timing of market entry: How beliefs and information distortion create market leadership

• Author: Nuno Alvim,Tiago Pires
• Date: 01 September 2017
• Published date: 01 September 2017
• DOI: http://doi.org/10.1111/ijet.12130

doi: 10.1111/ijet.12130

Optimism and timing of market entry: How beliefs and

information distortion create market leadership

Nuno Alvim∗and Tiago Pires†

This paper analyzes the relation between the timing of entry in markets and firms’ beliefs about

the state of the world. Wefurther study whether firms have incentives to become optimistic. We

consider an endogenous timing model with incomplete information about demand and show

the existence of a unique perfect Bayesian equilibrium where Bayesian firms with optimistic

beliefs become market leaders and firms with pessimistic beliefs become market followers.Firms

never become market followerswhen the y areable to choose their beliefs by forgetting bad news.

Our findings provide a justification for firms hiring and retaining managers with biased beliefs.

Key wor ds optimism, strategic delegation, endogenous timing

JEL classification C72, D03, D21, D82, L10, L20

Accepted 24 February 2016

1 Introduction

The failure of firms and congestion in markets is often associated with firms’ optimism and lack of

information at the time of entry. Empirical evidence shows that executives are particularly prone to

display optimism (Langer 1975; Larwood and Whittaker 1977; Marchand Shapira 1987), but empir-

ical and theoretical work establishing a relation between executives’beliefs and the timing of market

entry is scant. The existing empirical literature, however, revealsthat optimism can affect investment

decisions and cash flow sensitivity (Malmendier and Tate 2005a,b, 2008), capital expenditures and

likelihood of acquisition (Glaser et al. 2008), and innovation (Galasso and Simcoe 2011; Hirshleifer

et al. 2012). In addition to these effects, we hypothesize that the level of information and firms’

perceptions about the state of the world affect entry decisions and competitive behavior in markets.

The relation between executives’ beliefs and market entry timing may indeed explain some firms’

incentives to hire executives with biased beliefs (Malmendier and Tate 2008; Galasso and Simcoe

2011; Hirshleifer et al. 2012).

The main aim of this paper is to study how heterogeneous beliefs about demand affect the timing

of market entry. A natural question that arises in the presence of heterogeneous beliefs is why firms

∗RBB Economics, London, UK. Email: nuno.alvim@rbbeconomics.com.

†Department of Economics, University of North Carolina,Chapel Hill, North Carolina, USA

Weare particularly g rateful toLuis Santos-Pinto because the paper builds on earlier joint work and some of the ideas of

this paper were proposed by him. Weare also grateful to Eddie Dekel, Marciano Siniscalchi, William Rogerson, Marco

Ottaviani, David Henriques, and Pedro Rey-Biel for useful comments and discussions. Nuno Alvim acknowledges the

financial support of Fundac¸˜

ao Ciˆ

encia e Tecnologia. This paper was developed during PhD studies at the Department

of Economics and Economic §History, Universitat Auto‘noma de Barcelona. Tiago Pires gratefully acknowledges the

financial support from Fundac¸˜

ao para a Ciˆ

encia e Tecnologiaunder scholarship no. SFRH/BD/43857/2008. Tiago Pires,

passed away in April 2016. His talent, friendship and optimism are deeply missed.

International Journal of Economic Theory 13 (2017) 289–311 © IAET 289

International Journal of Economic Theory

Optimism and timing of market entry Nuno Alvim and Tiago Pires

would differ in their beliefs about demand. We therefore analyze possible sources of heterogeneous

beliefs and whether firms have incentives to become optimistic.1

We propose a basic framework that extends the endogenous timing model of Hamilton and

Slutsky (1990) where two players compete on quantities and must decide whether to enter the

market in period 1 or in period 2. Our model departs from the standard framework by assuming that

firms have incomplete information about demand and modeling a possible source of heterogeneous

beliefs.

We pursue the analysis in a sequential manner. We start by assuming that firms are completely

uninformed about demand: they only know that the true state of demand is either high or low. Firms

are Bayesian and thus have subjectivebeliefs about the true state of demand, which may differ across

firms. We next analyze why firms have different beliefs. In this analysis we assume there is a stage,

which precedes the entry decision, where firms can choose actions that affect their posterior beliefs.

In order to model this preceding stage, we extendthe model proposed by B ´

enabou and Tirole (2002)

by assuming that there exists a period 0 where firms receive a signal about the true demand, and that

firms have access to a mechanism that allows them to forget the received signal.

Our model supposes that there is an entrepreneur or a manager who chooses all the firm’s

actions. In this way, the model enables us toe valuatethe benefits and losses of hir ing managers who

are intrinsically more optimistic or pessimistic than others. The paper is therefore related to the

literature on strategic delegation. We do not enter into a discussion of this literature and thus take

the view, without loss of generality, that the results stem from a firm where decisions are taken by a

manager who maximizes firm value.2

We show that in the basic framework there exists a unique perfect Bayesian equilibrium. In

equilibrium, firms with more positive beliefs about the state of the world become market leaders,

whereas firms with more negative beliefs about the state of the world become market followers.

The results are consistent with anecdotal evidence of excessive and earlier entry of firms with more

optimistic managers or entrepreneurs.

If firms receive signals about demand but some of them have the possibility of forgetting bad

news, equilibrium outcomes satisfying forward induction are such that the firm with the possibility of

forgetting bad news always movesfirst, thus avoiding the lowest profit of becoming a market follower.

One interpretation of this result is that firms with the possibility of hiring or delegating decisions

to an optimistic manager are better than firms without this possibility, even when the delegation

does not occur. Our results thereforeprovide a justification for firms to hire overconfident managers

(Malmendier and Tate 2008; Galasso and Simcoe 2011; Hirshleifer et al. 2012).

The paper is related to three topics in the economics literature: endogenous timing decisions,

optimism, and strategic delegation. In traditional industrial organization models, firms may play

simultaneously or sequentially, but the choice of the game to be played is taken as an assumption

and not as a choice of firms. Endogenous timing models avoid this limitation by endogenizing the

decision to play a simultaneous or a sequential game. In a seminal paper, Hamilton and Slutsky

(1990) propose a model with two players who must decide on a quantity to be produced in one of

two periods before the market clears. If a player commits to a quantity in the first period, she acts

1In our model optimism is defined as an overstatement of the market size.

2Wecould interpret our results as obtained from a model with decisions made by internal organization structures where a

specific behavior or beliefs emerge as dominant. As we are concerned with firm behavior in markets rather than with the

internal organization of firms, the specific decision process within the firm is not relevant as long as the decision-maker

maximizes the firm’svalue. We therefore assume there are no principal–agent problems within the firm.

290 International Journal of Economic Theory 13 (2017) 289–311 © IAET