Economic and Psychological Theories of Forecast Bias and Learning: Evidence from U.S. Business Managers' Forecasts

Abstract

Economists and psychologists have each puzzled over the nature of decision making and the formation of expectations. Mainstream economists currently base their theory of expectation formation on the assumption of rationality Rationality implies unbiased forecasts and learning from past mistakes. Psychologists, however, see people as guided by processes other than the assumption of rationality. These processes often result in biased predictions and a failure to learn from past mistakes. This paper uses Conference Board data to examine the forecasts of business managers for evidence of bias and learning. Our analysis reveals systematically biased decision making by business executes in nearly every industry studied. The managers in the sample proved to be overly optimistic. In addition we find evidence of the learning that economists predict. However, this learning is of little consequence to the accuracy of managerial forecasts. These outcomes are analyzed using both the economics and cognitive psychology literature.Expectation; Forecast; Forecasts; Learning; Prediction; Rationality