Competing Models

José Luis Montiel Olea, Pietro Ortoleva, Mallesh M Pai and Andrea Prat

The Quarterly Journal of Economics, 2023, vol. 137, issue 4, 2419-2457

Abstract: Different agents need to make a prediction. They observe identical data, but have different models: they predict using different explanatory variables. We study which agent believes they have the best predictive ability—as measured by the smallest subjective posterior mean squared prediction error—and show how it depends on the sample size. With small samples, we present results suggesting it is an agent using a low-dimensional model. With large samples, it is generally an agent with a high-dimensional model, possibly including irrelevant variables, but never excluding relevant ones. We apply our results to characterize the winning model in an auction of productive assets, to argue that entrepreneurs and investors with simple models will be overrepresented in new sectors, and to understand the proliferation of “factors” that explain the cross-sectional variation of expected stock returns in the asset-pricing literature.

Date: 2023
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