Exploiting overconfidence: optimal contracts with heterogeneous beliefs

This study investigates a principal–agent model with moral hazard and heterogeneous beliefs. With homogeneous beliefs, moral hazard increases the contract’s sensitivity to the outcome to ensure that the agent does not take a lower action than that chosen by the principal. With heterogeneous beliefs, side betting between the principal and agent leads to actions whereby moral hazard decreases the contract’s sensitivity to the outcome to ensure that the agent does not take a higher action than that chosen by the principal. Conditions on the primitives of the model are provided for monotonicity of the optimal contract and applicability of the first-order approach.