Expert Advice, Control, and Heterogeneous Beliefs

Leonidas E. de la Rosa, School of Economics and Management, University of Aarhus

Abstract

In this paper, I study the effects of overconfidence in an investment-decision setting. A risk-averse agent privately observes information relevant to an investment decision, which he can then report to a principal. In a standard common-priors setting, the optimal contract provides full insurance to the agent: the principal pays a fixed wage to the agent, asks him to reveal his information, and implements the efficient investment rule. When the agent overestimates the expected revenue of the project following investment, however, he is willing to "wager" on success against the (relatively pessimistic) principal, and hence bear some project risk in equilibrium. In addition, because what the principal considers to be the optimal investment rule is too conservative according to the agent's beliefs and the agent holds some stake in the project, he will accept a lower fixed payment in exchange for a more liberal investment rule. This can be interpreted as the principal transferring some control to the agent. It is somewhat counterintuitive that the principal will surrender more control to an agent with whom she disagrees more sharply.