A Rationale for Hiring Irrationally Overconfident Managers

Oded Palmon*, Itzhak Venezia

*Corresponding author for this work

Research output: Chapter in Book/Report/Conference proceedingChapterpeer-review

Abstract

The viability of managerial overconfidence is perplexing since it has been shown to lead managers to erroneous and costly decisions. This chapter addresses this issue by exploring the impact of managerial overconfidence on managerial effort, executive compensation, and the welfare of stockholders and managers. Overconfidence affects managerial effort directly and indirectly. The direct effect is that the optimal effort chosen by managers is positively related to their level of overconfidence. The indirect impact is through the influence on stockholders’ choices of contract parameters. Thus, managerial overconfidence helps mitigate the well-known conflict of interest between managers and stockholders that induces managers to exert effort levels that are lower than the socially optimal levels. We construct a measure of the combined welfare of managers and stockholders and show that it is positively related to managerial overconfidence, thus providing an explanation to the persistence of this bias.

Original languageEnglish
Title of host publicationEncyclopedia of Finance, Third Edition
PublisherSpringer International Publishing
Pages1581-1598
Number of pages18
ISBN (Electronic)9783030912314
ISBN (Print)9783030912307
DOIs
StatePublished - 1 Jan 2022

Bibliographical note

Publisher Copyright:
© Springer Nature Switzerland AG 2022.

Keywords

  • Behavioral biases
  • Incentive options
  • Managerial effort
  • Overconfidence

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