Overconfidence and Moral Hazard

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.