Managerial Compensation Contracts and Overconfidence

Abstract

In this paper we analyze how overconfidence affects the principal-agent relationship when both the principal and the agent are assumed to be overconfident with respect to the quality of a common signal on the future state of nature. We study the impact of that psychological bias on both the compensation contract which the principal offers to the agent and the severity of the moral hazard problem. Most notably, our analysis indicates that a more pronounced overconfidence bias generally reduces the agency costs but enhances the incentive component of the compensation contract as well as the agent's effort. Therefore we conclude that overconfidence plays a crucial role in the design of incentive compatible compensation contracts. Furthermore, we find that from the principal's perspective overconfidence is advantageous only if favorable information about the future state of nature is available. If poor signals are available the overconfidence bias is detrimental to the principal.

Keywords: Principal-agent theory, overconfidence, sharing rule, compensation contract, agency costs, moral hazard, behavioral finance, corporate finance

JEL Classification: D82, G34, J33