Overconfidence and Moral Hazard

University of Aarhus Economics Working Paper No. 2007-8

45 Pages Posted: 10 Jun 2008 Last revised: 28 Aug 2008

See all articles by Leonidas Enrique de la Rosa

Leonidas Enrique de la Rosa

Aarhus University - Department of Economics and Business Economics

Multiple version iconThere are 2 versions of this paper

Date Written: April 10, 2007

Abstract

In this paper, I study the effects of overconfidence 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 overconfidence can have conflicting effects on the equilibrium contract. On the one hand, an overconfident agent disproportionately values success-contingent payments, and thus prefers higher-powered incentives. On the other hand, if the agent is overconfident in particular about the extent to which his actions affect the likelihood of success, lower-powered incentives are sufficient to induce any given effort level. If the agent is overall moderately overconfident, the latter effect dominates; because the agent bears less risk in this case, he actually benefits from his overconfidence. If the agent is significantly overconfident, the former effect dominates; the agent is then exposed to an excessive amount of risk, which is harmful to him. An increase in overconfidence - either about the base probability of success or the extent to which effort affects it - makes it more likely that high levels of effort are implemented in equilibrium.

Keywords: overconfidence, heterogeneous beliefs, moral hazard

JEL Classification: A12, D81, D82

Suggested Citation

de la Rosa, Leonidas Enrique, Overconfidence and Moral Hazard (April 10, 2007). University of Aarhus Economics Working Paper No. 2007-8, Available at SSRN: https://ssrn.com/abstract=1141783 or http://dx.doi.org/10.2139/ssrn.1141783

Leonidas Enrique De la Rosa (Contact Author)

Aarhus University - Department of Economics and Business Economics ( email )

Fuglesangs Alle 4
Aarhus, 8210
Denmark

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