Control Under Disagreement

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 agency setting. Principal and agent agree on some investment rule that is contingent on a public signal. In a standard common-priors setting, the optimal contract provides full insurance to the agent: the principal pays a fixed wage to the agent and implements the efficient investment rule. When the agent overestimates his ability (the expected revenue of the project following a decision to invest), however, he is willing to "wager" on success against the relatively pessimistic principal and hence bears 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. A straightforward interpretation of this result is that the principal is 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.