CEO Overconfidence, Moral Hazard, and Investment

40 Pages Posted: 27 Oct 2020

See all articles by Ramji Balakrishnan

Ramji Balakrishnan

University of Iowa - Department of Accounting

George Drymiotes

Texas Christian University

Shiva Sivaramakrishnan

Rice University

Joyce Tian

University of Waterloo - School of Accounting and Finance

Date Written: August 25, 2020

Abstract

Using an agency theory framework, we examine the effect of managerial overconfidence on the interaction between planning and control problems. We consider a typical setting in which a manager makes an investment decision involving project selection and a production decision to implement the chosen project. Thus, adverse selection and moral hazard problems affect different facets of management decision making, which allows us to examine how overconfidence affects the interaction between adverse selection and moral hazard. We show that overall welfare implications depend on the kind of overconfidence: productivity-related or state-related. When the agent overestimates the productivity of his effort, the principal can actually exploit the overconfidence and induce him to provide more effort at lower cost. However, overconfidence can either exacerbate an existing overinvestment problem or it can mitigate an existing underinvestment problem. We show that productivity-related overconfidence unequivocally improves the principal's welfare. On the contrary, state-related overconfidence aggravates the effort incentive problem but can ameliorate the underinvestment problem. Overall, state-related overconfidence decreases investor welfare, consistent with the negative connotation we often ascribe to overconfidence.

Keywords: Feedback, Feedforward, overinvestment, underinvestment

JEL Classification: M41

Suggested Citation

Balakrishnan, Ramji and Drymiotes, George and Sivaramakrishnan, Shiva and Tian, Joyce, CEO Overconfidence, Moral Hazard, and Investment (August 25, 2020). Available at SSRN: https://ssrn.com/abstract=3680313 or http://dx.doi.org/10.2139/ssrn.3680313

Ramji Balakrishnan

University of Iowa - Department of Accounting ( email )

108 Pappajohn Business Building
Iowa City, IA 52242-1000
United States
319-335-0958 (Phone)
319-335-1956 (Fax)

George Drymiotes

Texas Christian University ( email )

M.J. Neeley School of Business
TCU Box 298530
Fort Worth, TX 76129
United States
817 257 5448 (Phone)

Shiva Sivaramakrishnan

Rice University ( email )

6100 South Main Street
Houston, TX 77005-1892
United States

Joyce Tian (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1
Canada

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