Overconfidence in the Continuous-Time Principal-Agent Problem
33 Pages Posted: 25 Jun 2002
Date Written: February 2003
In this paper we analyze the impact of overconfidence on the continuous-time principal-agent problem when both the risk neutral principal and the risk averse agent are assumed to be subject to this psychological bias. The first-best and second-best sharing rules as well as the agency costs are derived when the outcome process which is controlled privately by the agent is not observable directly by the two parties to the contract but a common signal on the outcome process is available. Both the first-best contract and the first-best control are reported to be independent of the parties' overconfidence. In contrast the second-best contract and the second-best control, which is always less than the first-best control, as well as the agency costs depend on the degree of overconfidence. The comparative static results document that the second-best control decreases but the agency costs increase with the parties' overconfidence. The various components of the second-best sharing rule exhibit mixed comparative static results with respect to the degree of overconfidence.
Keywords: principal-agent theory, overconfidence, continuous-time, sharing rule, compensation contract, agency costs, moral hazard, behavioral finance, corporate finance
JEL Classification: D82, G34, J33
Suggested Citation: Suggested Citation