Limited information and entry decision: A source of entrepreneurial overconfidence

This model shows how seemingly irrational behavior of new entrants can be explained by a lack of complete information. The overestimation of future earnings potential and subsequent over entry is driven by the assumption that income information containing profit levels of firms who have gone under is not accessible. Whenever an observer contemplating entry is not aware of the limited nature of information, she would be bound to overinflate her estimate of earnings potential. This result arises even though the entrant has a correct prior belief. This correct information gets distorted during Bayesian updating, involving an analysis of incomplete information. I also find that increasing the number of signals during sampling is likely to make the resulting bias worse. On the other hand, collecting information about the entire profit population (observing for several periods prior to entry) helps to reduce bias. For any agent having more precise information about prior beliefs helps, while having more precise information about current profit distributions is likely to make the bias larger. Dynamic changes in system parameters such as the variances of prior and/or signal distributions, and the number of incumbents produce results which may explain life cycles of an industry as well as the different hazard rates observed. Empirical verification is needed where the hazard rate would serve as a dependent variable. The lifespan of an industry, number of incumbents, and quality of information should serve as independent variables. This paper serves as a pilot investigation into the role of information for the study of entrepreneurship.