Overconfidence and Renegotiation
29 Pages Posted: 23 Oct 2023
We study the implications of heterogeneous beliefs in a moral-hazard setting without commitment. Lack of commitment is costly because the principal cannot commit to not offering the optimal risk-sharing contract after the agent exerts effort, leading to the impossibility of implementing costly effort as a pure strategy when the principal and the agent have homogeneous beliefs. With heterogeneous beliefs, the optimal risk-sharing contract varies with the outcome, allowing costly effort levels to be implemented in pure strategies. With mixed-strategy implementation, we show that overconfidence improves the mixing equilibrium because it decreases the difference between the second-best contract and the optimal risk-sharing contract.
Keywords: Overconfidence, moral hazard, Renegotiation
Suggested Citation: Suggested Citation