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Overconfidence and Moral Hazard

  • Leonidas Enrique de la Rosa

    ()

    (School of Economics and Management, University of Aarhus, Denmark)

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 prob- ability 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 overcon- fident, 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.

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Paper provided by School of Economics and Management, University of Aarhus in its series Economics Working Papers with number 2007-08.

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Length: 43
Date of creation: 10 Jul 2007
Date of revision:
Handle: RePEc:aah:aarhec:2007-08
Contact details of provider: Web page: http://www.econ.au.dk/afn/

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  2. Dan Lovallo & Colin Camerer, 1999. "Overconfidence and Excess Entry: An Experimental Approach," American Economic Review, American Economic Association, vol. 89(1), pages 306-318, March.
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  5. Simon Gervais & Terrance Odean, . "Learning To Be Overconfident," Rodney L. White Center for Financial Research Working Papers 5-97, Wharton School Rodney L. White Center for Financial Research.
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  8. Murphy, Kevin J., 1999. "Executive compensation," Handbook of Labor Economics, in: O. Ashenfelter & D. Card (ed.), Handbook of Labor Economics, edition 1, volume 3, chapter 38, pages 2485-2563 Elsevier.
  9. Smith, C.W. & Watts, R.L., 1992. "The Investment Oppotunity set and Corporate Financing, Dividend and Compensation Policies," Papers 92-02, Rochester, Business - Financial Research and Policy Studies.
  10. Bertrand Villeneuve, 2000. "The Consequences for a Monopolistic Insurance Firm of Evaluating Risk Better than Customers: The Adverse Selection Hypothesis Reversed," The Geneva Risk and Insurance Review, Palgrave Macmillan, vol. 25(1), pages 65-79, June.
  11. Ulrike Malmendier & Geoffrey Tate, 2004. "CEO Overconfidence and Corporate Investment," NBER Working Papers 10807, National Bureau of Economic Research, Inc.
  12. Morris, Stephen, 1995. "The Common Prior Assumption in Economic Theory," Economics and Philosophy, Cambridge University Press, vol. 11(02), pages 227-253, October.
  13. Roland Bénabou & Jean Tirole, 2002. "Self-Confidence And Personal Motivation," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 871-915, August.
  14. Akerlof, George A & Dickens, William T, 1982. "The Economic Consequences of Cognitive Dissonance," American Economic Review, American Economic Association, vol. 72(3), pages 307-19, June.
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