A Rationale for Hiring Irrationally Overconfident Managers

The viability of managerial overconfidence is perplexing since it has been shown to lead managers to erroneous and costly decisions. This paper 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.