Overconfidence and Moral Hazard

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

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NOTICE: this is the author’s version of a work that was accepted for publication in Games and Economic Behavior. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Games and Economic Behavior, [VOL 73, ISSUE 2, (November 2011), 429-451] doi:10.1016/j.geb.2011.04.001 [published]

Abstract

In this paper, I study the effects of overconfidence on incentive contracts in a moral-hazard framework. Agent overconfidence can have conflicting effects on the equilibrium contract. On the one hand, an optimistic or overconfident agent disproportionately values success-contingent payments, and thus prefers higher-powered incentives. On the other hand, if the agent overestimates the extent to which his actions affect outcomes, lower-powered incentives are sufficient to induce any given effort level. If the agent is moderately overconfident, the latter effect dominates. Because the agent bears less risk in this case, there are efficiency gains stemming from his overconfidence. If the agent is significantly overconfident, the former effect dominates; the agent is then exposed to an excessive amount of risk, and any gains arise only from risk-sharing under disagreement. An increase in optimism or overconfidence increases the effort level implemented in equilibrium.