Optimism-Driven Decisions of Real Estate Developers Under Demand Uncertainty

We develop a set of theoretical models to show how differences in real estate developers' optimism about market demand affects construction and sales decisions. The model is a variation of asymmetric Cournot duopoly where developers choose levels of output conditioned on their rivals' output and their own levels of optimism in a stochastic environment. The resulting Nash equilibrium is used to analyze effects of differences in optimism across developers and sales levels after the realization of stochastic demand. Our analysis shows that optimistic developers construct more housing and hold more inventories when facing higher demand uncertainty. Developers' overconfidence creates value in terms of optimal profit and market share. We also discuss how updating beliefs over multi-periods could turn a pessimistic developer to an optimistic one, and vice versa. The paper thus provides some behavioral insights into puzzling phenomena such as overconfidence, overbuilding, construction timing, and inventory holding