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Incentive Contracts for Overoptimistic Managers

Author

Listed:
  • Yuri Khoroshilov

    (University of Ottawa)

Abstract

This paper analyzes an optimal incentive contract for an overoptimistic manager who overestimates the investment potential of the firm. It shows that, compared with a rational manager, an overoptimistic manager is willing to accept a linear incentive contract with a lower fixed wage. At the same time, overoptimism also leads to overinvestment. Given the trade-off between lower labor cost and investment misallocation, we show that shareholders prefer to hire an overoptimistic manager when production is not capital intensive, when the output is not too volatile and when the manager has a higher reservation utility.

Suggested Citation

  • Yuri Khoroshilov, 2012. "Incentive Contracts for Overoptimistic Managers," Economics Bulletin, AccessEcon, vol. 32(2), pages 1687-1694.
    • Handle: RePEc:ebl:ecbull:eb-12-00119
    as

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    File URL: http://www.accessecon.com/Pubs/EB/2012/Volume32/EB-12-V32-I2-P162.pdf
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    References listed on IDEAS

    as
    1. Anand M. Goel & Anjan V. Thakor, 2005. "Green with Envy: Implications for Corporate Investment Distortions," The Journal of Business, University of Chicago Press, vol. 78(6), pages 2255-2288, November.
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    3. Anand M. Goel & Anjan V. Thakor, 2008. "Overconfidence, CEO Selection, and Corporate Governance," Journal of Finance, American Finance Association, vol. 63(6), pages 2737-2784, December.
    4. Banker, Rd & Datar, Sm, 1989. "Sensitivity, Precision, And Linear Aggregation Of Signals For Performance Evaluation," Journal of Accounting Research, Wiley Blackwell, vol. 27(1), pages 21-39.
    5. Anna Dodonova & Yuri Khoroshilov, 2006. "Optimal Incentive Contracts for Loss‐Averse Managers: Stock Options versus Restricted Stock Grants," The Financial Review, Eastern Finance Association, vol. 41(4), pages 451-482, November.
    6. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    incentive contract; overoptimistic manager; behavioral finance;
    All these keywords.

    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance
    • C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory

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