Department of Economics and Business Economics

Overconfidence and Moral Hazard

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  • School of Economics and Management
In this paper, I study the effects of overconfidence on incentive contracts in
a moral-hazard framework. Agent overconfidence can have conflicting effects on
the equilibrium contract. On the one hand, an optimistic or overconfident agent
disproportionately values success-contingent payments, and thus prefers
higher-powered incentives. On the other hand, if the agent overestimates
the extent to which his actions affect outcomes,
lower-powered incentives are sufficient to induce any given effort level. If
the agent is moderately overconfident, the latter effect dominates. Because
the agent bears less risk in this case, there are efficiency gains stemming
from his overconfidence. If the agent is significantly overconfident, the
former effect dominates; the agent is then exposed to an excessive amount of
risk, and any gains arise only from risk-sharing under disagreement. An increase in
optimism or overconfidence increases the effort level implemented
in equilibrium.
Original languageEnglish
JournalGames and Economic Behavior
Volume73
Issue2
Pages (from-to)429 - 451
ISSN0899-8256
DOIs
Publication statusPublished - Nov 2011

    Research areas

  • overconfidence, heterogeneous beliefs, moral hazard

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