The Risk of Failure: Trial and Error Learning and Long-Run Performance

Abstract

Innovation is often the key to sustained progress, yet innovation itself is difficult and highly risky. Success is not guaranteed as breakthroughs are mixed with setbacks and the path of learning is typically far from smooth. How decision makers learn by trial and error and the efficacy of the process are inextricably linked to the incentives of the decision makers themselves and, in particular, to their tolerance for risk. In this paper, we develop a model of trial and error learning with risk averse agents who learn by observing the choices of earlier agents and the outcomes that are realized. We identify sufficient conditions for the existence of optimal actions. We show that behavior within each period varies in risk and performance and that a performance trap develops, such that low performing agents opt to not experiment and thus fail to gain the knowledge necessary to improve performance. We also show that the impact of risk reverberates across periods, leading, on average, to divergence in long-run performance across agents. (JEL D81, D83, O31, O38)