Biased-Belief Equilibrium

Abstract. We investigate how distorted, yet structured beliefs, emerge in strategic situations. Specifically, we study two-player games in which each player is endowed with a biased-belief function that represents the discrepancy between a player’s beliefs about the opponent's strategy and the actual strategy. Our equilibrium condition requires that: (1) each player chooses a best response strategy to his distorted belief about the partner’s strategy, and (2) the distortion functions form best responses to one another, in the sense that if one of the players is endowed with a different distortion function, then that player is outperformed in the game induced by this new distortion function. Our analysis characterizes equilibrium outcomes and identify the belief biases that support these equilibrium outcomes in different strategic environments.