Adam Smith and the Welfare Cost of Optimism

Adam Smith, in his well-known defense of interest ceilings, is shown to have stumbled upon a source of welfare losses which, though pervasive and potentially fundamental, has never been further explored. Such losses occur because competition allocates resources to the highest bidders, whose expectations tend to have an optimistic bias. Incorrect expectations, however, may cause output losses. In the first section of the paper. Smith's argument about ceiling rates is generalized to a proposition about resource allocation. The second section scans 20th century literature, from Frank Knight to the "winner's curse", for traces of this proposition. In section 3 the argument is formalized into a model of resource allocation among three agents. The final section extends this model to any number of agents.