Overconfidence and Speculative Bubbles∗

Motivated by the behavior of asset prices, trading volume and price volatility during historical episodes of asset price bubbles, we present a continuous time equilibrium model where overconfidence generates disagreements among agents regarding asset fundamentals. With short-sale constraints, an asset owner has an option to sell the asset to other overconfident agents when they have more optimistic beliefs. As in Harrison and Kreps (1978), this re-sale option has a recursive structure, that is, a buyer of the asset gets the option to resell it. Agents pay prices that exceed their own valuation of future dividends because they believe that in the future they will find a buyer willing to pay even more. This causes a significant bubble component in asset prices even when small differences of beliefs are sufficient to generate a trade. In equilibrium, large bubbles are accompanied by large trading volume and high price volatility. Our model has an explicit solution, which allows for several comparative statics exercises. Our analysis shows that while Tobin’s tax can substantially reduce speculative trading when transaction costs are small, it has only a limited impact on the size of the bubble or on price volatility. We also give an example where the price of a subsidiary is larger than its parent firm. ∗This paper was previously circulated under the title “Overconfidence, Short-Sale Constraints and Bubbles.” Scheinkman’s research was supported by the Chaire Blaise Pascal and the National Science Foundation. We would like to thank Patrick Bolton, Markus Brunnermeier, John Cochrane, George Constantinides, Darrel Duffie, Ivar Ekeland, Ravi Jagannathan, Owen Lamont, Marcelo Pinheiro, Chris Rogers, Tano Santos, Walter Schachermayer, Harald Uhlig, Dimitri Vayanos, two anonymous referees and seminar participants at various institutions and conferences for comments. †Princeton University and Université Paris-Dauphine. E-mail: [email protected]; Phone: (609) 258-4020. ‡Princeton University. E-mail: [email protected]; Phone: (609) 258-0282.