Overconfidence and moral hazard

In this paper, I study the e¤ects of overcon…dence on incentive contracts in a moral-hazard framework in which principal and agent knowingly hold asymmetric beliefs regarding the probability of success of their enterprise. Agent overcon…dence can have con‡icting e¤ects on the equilibrium contract. On the one hand, an overcon…dent agent disproportionately values successcontingent payments, and thus prefers higher-powered incentives. On the other hand, if the agent is overcon…dent in particular about the extent to which his actions a¤ect the likelihood of success, lower-powered incentives are su¢ cient to induce any given e¤ort level. If the agent is overall moderately overcon…dent, the latter e¤ect dominates; because the agent bears less risk in this case, he actually bene…ts from his overcon…dence. If the agent is signi…cantly overcon…dent, the former e¤ect dominates; the agent is then exposed to an excessive amount of risk, which is harmful to him. An increase in overcon…dence— either about the base probability of success or the extent to which e¤ort a¤ects it— makes it more likely that high levels of e¤ort are implemented in equilibrium. Keywords: overcon…dence, heterogeneous beliefs, moral hazard. JEL Classi…cation: A12, D81, D82. School of Economics and Management, University of Aarhus. A version of this paper is part of my Ph.D. dissertation at the University of California, Berkeley. I am particularly grateful to Benjamin Hermalin, Matthew Rabin, and especially Botond K1⁄2oszegi for their insightful comments. I am also very grateful to Robert Anderson, Peter Ove Christensen, Ulrike Malmendier, Dayanand Manoli, John Morgan, Terrance Odean, Yuliy Sannikov, Chris Shannon, Adam Szeidl, and seminar participants at University of Aarhus, UC Berkeley, CIDE, EPGE–FGV, Melbourne Business School, Oberlin College, and Queen’s University for helpful comments and discussion.