Overconfidence and Moral Hazard

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