Economic Forces Shape Beliefs: a Model of Investment Under Fundamental Uncertainty

Abstract: Capitalist systems regularly produce innovations in the form of novel technologies and business models that put interested financial investors in a situation of fundamental uncertainty. Absent a factual basis for assigning probabilities to possible outcomes, investors often turn to subjective prior beliefs about an innovations' chances of success or failure. In this paper, we present a theoretical model of how investors adopt subjective priors under fundamental uncertainty. The model's core element is a "narrative contest", a competition in which profit-seeking financial intermediaries wish to influence investors' priors about the chance that a recent innovation will indeed deliver a high rate of return. Using this framework, we identify factors that make investors more likely to adopt "exuberant" priors, i.e., priors that lead them to ignore objective warning signs for too long. We also demonstrate how our model can guide a financial regulator that, realistically, does not have better information than the investors.