When Better-than-average Becomes Average

For some time, researchers have scratched their heads about the overconfidence of entrepreneurs. A new study suggests that many entrepreneurs just aren’t very good at assessing the competition.

June 9, 2014

T.S. Eliot said it thusly: “Between the idea and the reality…falls the shadow.” Numbers—less poetically—say it another way: eighty-one percent of entrepreneurs consider their chance of success to be 70 percent or higher; one third assume their success is guaranteed. These are peculiar statistics given actual (low) rates of success, and they highlight a longstanding academic puzzle: what, precisely, accounts for such conspicuous confidence?

Daylian Cain of Yale University, and coauthors Don Moore (Berkeley) and Uriel Haran (Hebrew University of Jerusalem), has crafted an answer to this question. Published in the Strategic Management Journal, their article discusses how people tend to underestimate the quality of competition, leading to inflated expectations of success when entering juicy markets. (This underestimation is referred to as “overplacement.”) In more difficult markets, however, people tend to overestimate the quality of competition, leading to deflated expectations of success. As the article nicely explains, people are overconfident on easy tasks (“I know it was easy for me, I am less sure it was easy for others”) and underconfident on hard tasks (“I know it was hard for me, I am less sure it was hard for others”). But, if hard tasks breed underconfidence, how do entrepreneurs retain high levels of confidence, even on hard tasks?

To articulate an answer, the authors designed an experiment with two quizzes, one easy and one difficult. After completing the quizzes, participants estimated their scores and their competitors’ scores. They then chose to enter a market on either the easy or the difficult quiz. For half of the participants, the difficult quiz was associated with a large prize ($90) and the easy quiz was associated with a smaller prize ($45); prize amounts were reversed for the other half. The probability of winning a prize depended on relative quiz performance, with the lowest-ranked competitor receiving one ticket, the next competitor two tickets, and so on. A lottery draw determined the prizewinner.

Regardless of prize size and despite correctly predicting that the easy competition would be overcrowded, participants overwhelmingly chose to compete on the easy quiz. This decision was not heavily contingent on how well participants thought that they did on their own quiz. Rather, the choice was made on the nearly universal prediction that others probably performed worse on the easy quiz.

Rather than force a choice between entering an easy or difficult market, a second experiment with a similar design refined these results by allowing participants a chance to opt out of the contest altogether and get a guaranteed small sum of money. As the authors put it, “in reality, most potential entrepreneurs are not forced to choose between opening a restaurant and opening a magnesium mine. In fact, most people opt not to enter any entrepreneurial market.” Even with this opt-out alternative, results indicated that overplacement—a false sense of ‘better-than-average’—exerted a strong influence on participants’ decisions to enter the easy market. Overplacement may therefore be a powerful driver of excess market entry; and excess market entry can lead to kinks in economic efficiency. (The opt-out option also let underconfident people steer clear of difficult markets.)

The better a person believes that he or she is relative to others on a task, the higher the likelihood that that person will compete. If one forces a group of people into a hard task, as prior lab experiments often did, then entrants will generally feel underconfident. But if people choose if and when to compete, then only the confident will enter markets: many miscalibrated entrants (and some well-calibrated entrants) will enter the easy markets, while fewer miscalibrated entrants (and some well-calibrated entrants) will enter the difficult markets. Actual entrants will tend to be confident, even in difficult markets. And easy markets will be flooded.

Practically speaking, these results suggest that it may not be enough to simply warn entrepreneurs to ‘first, consider the competition,’ as their assessments of the competition is commonly biased. Perhaps the most effective way to improve considerations about competition is by giving entrepreneurs more accurate information about the landscape: if one knows that the task is easy for everyone else, one’s overplacement on that task tends to disappear. The challenge faced by potential market entrants is accurately assessing the relative value of their work. After all, it is not whether one can make a hamburger well that leads to success of a burger joint, but, among other things, whether one can do so better than the competition. As the old joke goes, when two campers are being chased by a hungry bear, one needn’t outrun the bear, only the other camper.