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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 Department of Economics and Business Economics, Aarhus University 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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