Abstract
Excess entry refers to the high failure rate of new entrepreneurial ventures. Economic explanations suggest “hit and run” entrants and risk-seeking behavior. A psychological explanation is that people (entrepreneurs) are overconfident in their abilities (Camerer & Lovallo, 1999). Characterizing entry decisions as ambiguous gambles, we alternatively suggest – following Heath and Tversky (1991) – that people seek ambiguity when the source of uncertainty is related to their competence. Overconfidence, as such, plays no role. This hypothesis is confirmed in an experimental study that also documents the phenomenon of reference group neglect. Finally, we emphasize the utility that people gain from engaging in activities that contribute to a sense of competence. This is an important force in economic activity that deserves more explicit attention.
Explanations of the excess entry phenomenon have been grounded in both economics and psychology.
The standard economic story is that high profits attract entry and entrants bid away these profits, eventually pushing the industry into a long run equilibrium with no excess returns and a given number of firms. Similarly, whenever profits fall below “normal” levels, exit occurs and this depopulation of the industry raises profitability for the survivors back to equilibrium. From this perspective, failures are “hit and run” entrants that have only a small chance of success in the limited period when the industry exhibit extra profits. Starting a new business therefore makes sense at those moments when potential entrepreneurs receive positive feedback from the market.
Alternatively, starting a business can be framed as facing a gamble where the probability of winning is extremely low but the payoff for success is very large. This explanation enlarges the former perspective by accounting for uncertainty, information, and risk attitudes in determining entry decisions. This can result in excess entry with respect to a limited and unknown market capacity and consequently individual failures.
These explanations grounded in economics assume full rationality on the part of agents. In contrast, psychological explanations suggest two kinds of “mistakes.” One is the phenomenon of “competitive blind spots,” that is, agents fail to appreciate how many competitors they will face. The second is overconfidence, a phenomenon that has been documented in many contexts (Einhorn & Hogarth, 1978; Kahneman, Slovic, & Tversky, 1982; Klayman, Soll, Gonzalez-Vallejo, & Barlas, 1999). Agents may forecast competition accurately but fail in evaluating their own chances of success. Specifically, the decision to enter is taken even if negative industry profits are expected because of a belief in succeeding where others will fail.
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