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Correlation neglect, incentives, and welfare

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  • Klümper, Andreas
  • Kräkel, Matthias

Abstract

We modify the Holmström–Milgrom model by letting the agent neglect the correlation between performance measures. Whenever true and perceived correlation are sufficiently low, correlation neglect enhances material welfare and expected profit. Otherwise, material welfare diminishes, and the agent may benefit.

Suggested Citation

  • Klümper, Andreas & Kräkel, Matthias, 2020. "Correlation neglect, incentives, and welfare," Economics Letters, Elsevier, vol. 192(C).
    • Handle: RePEc:eee:ecolet:v:192:y:2020:i:c:s0165176520301312
    DOI: 10.1016/j.econlet.2020.109171
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    References listed on IDEAS

    as
    1. de la Rosa, Leonidas Enrique, 2011. "Overconfidence and moral hazard," Games and Economic Behavior, Elsevier, vol. 73(2), pages 429-451.
    2. Holmstrom, Bengt & Milgrom, Paul, 1991. "Multitask Principal-Agent Analyses: Incentive Contracts, Asset Ownership, and Job Design," The Journal of Law, Economics, and Organization, Oxford University Press, vol. 7(0), pages 24-52, Special I.
    3. Benjamin Enke & Florian Zimmermann, 2019. "Correlation Neglect in Belief Formation," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 86(1), pages 313-332.
    4. Pietro Ortoleva & Erik Snowberg, 2015. "Overconfidence in Political Behavior," American Economic Review, American Economic Association, vol. 105(2), pages 504-535, February.
    5. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-328, March.
    6. Alex Rees-Jones & Ran Shorrer & Chloe J. Tergiman, 2020. "Correlation Neglect in Student-to-School Matching," NBER Working Papers 26734, National Bureau of Economic Research, Inc.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Behavioral contract theory; Moral hazard; Risk aversion;
    All these keywords.

    JEL classification:

    • A12 - General Economics and Teaching - - General Economics - - - Relation of Economics to Other Disciplines
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D9 - Microeconomics - - Micro-Based Behavioral Economics

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