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Contracts with Wishful Thinkers

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Abstract

Managers with anticipatory emotions have higher current utility if they are optimistic about the future. We study an employment contract between an (endogenously) optimistic manager and realistic investors. The manager faces a trade-off between ensuring that the chosen levels of effort reflect accurate news and savoring emotionally beneficial good news. We show that optimism may exacerbate incentive problems. Specifically, investors and manager agree over the optimal news recall when the manager's weight on anticipatory utility is low. For intermediate values, there is a conflict of interest and investors bear an extra-cost to have the manager recalling bad news. For high weights on anticipatory utility, investors become indifferent between inducing signal recollection or not, and a pooling equilibrium obtains, reminiscent of adverse selection models. We then extend the analysis to the case in which the parameter capturing anticipatory utility is the manager's private information. Last, we derive interesting testable predictions on the relationship between personality traits, managerial compensation and hiring policies.In a setting with a wishful thinking agent and a realistic principal, the paper studies how incentive contracts should be designed to control for both moral hazard and self-deception. The properties of the contract that reconciles the agent with reality depend on the weight the agent attaches to anticipatory utility. When this is small, principal and agent agree on full recollection. For intermediate values the principal bears an extra cost to make the agent recall bad news. For large weights the principal renounces inducing signal recollection. We extend the analysis to the case in which the parameter of anticipatory utility is private information. The distinction between the two settings assumes practical relevance if preferences can be related to personality characteristics as in this case the parameter of anticipatory utility could be learned through psychological testing.

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Bibliographic Info

Paper provided by Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy in its series CSEF Working Papers with number 258.

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Date of creation: 15 Sep 2010
Date of revision: 28 Oct 2012
Handle: RePEc:sef:csefwp:258

Note: A previous version has been circulated under the title “Optimal Compensation Contracts for Optimistic Managers.
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Keywords: Self-deception; anticipatory utility; contracts;

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