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Abstract
Previous studies have found underestimation of risk, or overconfidence, to be a key factor in
entrepreneurship. We use a simple model of competitive equilibrium to show that an irrational
under-estimation of risk provides a competitive advantage leading to a greater chance of survival
under competitive pressures. Overconfidence leads to greater investment, production levels,
average profit and greater variance of profits. Despite the greater variance of profits, if enough
producers under-estimate their risk, they should collectively drive more rational decision-makers
form the market. We illustrate a local equivalency between Kahneman and Tversky’s prospect
theory model, and a subjective expected utility model with decision-makers display
overconfidence. This model allows us to characterize risk attitudes through two primary effects:
diminishing marginal utility of wealth (rational), and diminishing distance perception
(behavioral). Diminishing distance perception is a simple measure of misperception of risk.
Results from economic simulations suggest that diminishing distance perception may be a more
important determinant of market behavior, and entrepreneurial success, than diminishing
marginal utility of wealth.