Abstract

We analyze a model where irrational and rational informed traders exchange a risky asset with competitive market makers. Irrational traders misperceive the mean of prior information (optimistic/ prssimistic bias), the variance of prior information (better/lower than average effect) and the variance of the noise in their privte signal (overconfidence/underconfidence bias). When market makers are rational we obtain results identical to Kyle and Wang (1997). However if market makers are irrational, we obtain that moderately underconfident traders can outperform rational ones and the irrational market makers can fare better thatn rational ones. lastly we find that extreme level of confidence implies high trading volume.