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Domotor, Erika
Ozbay, Erkut
Chapter 1 revisits the model of adverse selection under asymmetric information with the power of the rational inattention framework. I depart from the setup of Akerlof (1970) by revising its extreme information asymmetry assumption. Instead of assuming that the Seller is fully informed and the Buyer is fully uninformed, I consider a setting in which both parties areable to gather information, but at a cost. As a result, both the Seller and the Buyer become partially informed, and the information asymmetry is the consequence of the asymmetry in their incentives and unit information costs. This enhanced framework provides new insights into the implications of incomplete information for market outcomes, efficiency and welfare. When information asymmetries occur endogenously, they do not lead to market collapse, but they do create market inefficiencies. The Buyer is better off and the Seller is worse off compared to the efficient symmetric information benchmark. In Chapter 2, I propose a model that explains the evolution of overconfidence as being a result of the constrained utility-maximizing problem of a decision maker who is rationally inattentive to information, but at the same time biased towards more optimistic subjective beliefs.Empirical studies have shown that individuals with initially fewer skills have more confidence, but as their skill level increases, their overconfidence decreases. The phenomenon is well-known as the Dunning-Kruger effect in the psychology literature. I explain this effect by the simultaneous choice of subjective and objective information. In my model a non-materialistic utility component induces overly optimistic subjective beliefs, which are constrained by the cost of information distortion. The setup is tractable in a range of economic problems. Chapter 3 utilizes the Model of Overconfidence from Chapter 2 in an application which explains the excess entry and high drop out rate of entrepreneurs. In this setting I show that in the presence of overconfidence individuals enter businesses with lower than necessary skill levels to succeed. At the same time, they drop out due to underperforming even when their skill levels would be adequate to stay in, were they not overconfident. The gap between skill thresholds for entry and drop out results in the high failure rate of businesses.