Contracts with Wishful Thinkers

• Author: Maria Grazia Romano,Giovanni Immordino,Anna Maria C. Menichini
• Published date: 01 October 2015
• Date: 01 October 2015
• DOI: http://doi.org/10.1111/jems.12113

Contracts with Wishful Thinkers

GIOVANNI IMMORDINO

Dipartimento di Scienze Economiche e Statistiche

University of Naples Federico II, Via Cintia Monte S. Angelo, 80122, Napoli, Italy,and CSEF

giovanni.immordino@unina.it

ANNA MARIA C. MENICHINI

Dipartimento di Scienze Economiche e Statistiche

University of Salerno, Via Giovanni Paolo II, 84084 Fisciano (SA), Italy,and CSEF

amenichini@unisa.it

MARIA GRAZIA ROMANO

Dipartimento di Scienze Economiche e Statistiche

University of Salerno, Via Giovanni Paolo II, 84084 Fisciano (SA), Italy,and CSEF

maromano@unisa.it

In a setting with a wishful thinking agent and a realistic principal, the paper studies how incentive

contracts should be designed to control for both moral hazard and self-deception. The properties

of the contract that reconcile the agent with reality depend on the weight the agent attaches

to anticipatory utility. When this is small, principal and agent agree on full recollection. For

intermediate values the principal bears an extra cost to make the agent recall bad news. For large

weights, the principal gives up on inducing signal recollection. We also extend the analysis to

the case in which the parameter of anticipatory utility is private information.

1. Introduction

There is widespread psychological evidence that most individuals hold overly positive

evaluations about the self and exaggerated perceptions of control or unrealistic opti-

mism (Taylor and Brown, 1988).1Recent economic literature has tried to reconcile this

with individual decision making, by constructing models with endogenously wishful

thinkers. The present paper introduces moral hazard in such a model and studies an

employment contract between an endogenously optimistic agent and a realistic princi-

pal. Optimism is modeled assuming that the agent enjoys anticipatory utility, that is,

derives utility from the anticipation of his future payoff: the greater his futurepayoff, the

greater his current utility. A greater anticipatory utility can be achieved by suppressing

current bad information affecting future payoffs, thus expecting good outcomes more

We thank the editor, Daniel Spulber, an associate editor, and two anonymous referees for comments and

suggestions that greatly improved the paper. We are also indebted to Utpal Bhattacharya, Yeon-Koo Che,

Andy Newman, and Marco Pagano for many useful insights, and participants to the the First Workshop

ME@Velia(Ascea Marina), to the 6th CSEF-IGIER Symposium in Economics and Institutions (Capri), as well

as seminar participants at the Universit´

e de Paris Dauphine (Paris) and Cass Business School (London) for

their comments. A previous version has been circulated under the title “Optimal compensation contracts for

optimistic managers.” Usual disclaimer applies.

1. In the economic literature, such attitudes are especially documented for businessmen. For example,

Cooper et al. (1988) argue that entrepreneurs see their own chances for success higher than that of their peers,

whereas Malmendier and Tate(2005) and Malmendier and Tate (2008) find evidence that CEOs overestimate

their firms’ future performance.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 4, Winter 2015, 863–886

864 Journal of Economics & Management Strategy

often than is warranted. But because distorted beliefs distort actions, optimism has an

influence on decisions and exacerbates incentive problems. We study how the need to

control for both optimism and moral hazard affects the design of incentive contracts.

To analyze this problem, we develop a model that unifies various themes from

psychology and economics within a simple contract-theoretic framework. According to

an influential literature in psychology (Taylor and Brown, 1988), normal mental func-

tioning is skewed in a positive direction and processes of self deception—the active

misrepresentation of reality to the conscious mind—are characteristic of mental health

(Trivers,2000). The resulting biases guide the processing of information, such that mildly

negative or ambiguous information is distorted to be more positive than may actually be

the case. In particular, individuals adjust to threatening events by constructing benign

interpretations of the same events.2One of the many forces that may favor mechanisms

of self-deception is that positive illusions may give intrinsic benefits (Taylor and Brown,

1988; Trivers, 2000). As Taylor (1989) describes it, “It is just as easy to construe future

events in a manner that promises success and happiness rather than one that portends

failure. Self-deception can be healthful and bolstering if it doesn’t involve gambling one’s

resources beyond salvage.” The beneficial effect of self-deception is modeled in the eco-

nomic literature by assuming that prior to the resolution of uncertainty, individuals

experience feelings of anticipation. Through imperfect memory, they select their beliefs

so as to enjoy the greatest comfort or happiness, thus leading to cognitive dissonance.

However, thereare limits to the extent of self-deception. “At one level, [the normal

human mind] constructs beneficent interpretations of threatening events that raise self-

esteem and promote motivation; yet at another level, it recognizes the threat or challenge

that is posed by these events” (Taylor, 1989). Tocapture the “consciousness/awareness”

that rejoins individuals with reality, most of the theoretical literature has assumed indi-

viduals to be Bayesian information processors (Piccione and Rubinstein, 1997; B´

enabou

and Tirole, 2002): they areaware of the flaws of memory and in making choices take into

account the possibility of having suppressed unfavorable information.3

Our paper builds on this literature and by applying a game of belief management

`

alaB

´

enabou and Tirole (2002) into a principal-agent framework with wishful thinking

agents, inquires into how a principal should reward a forgetful agent in the aware-

ness that well-designed payoffs can limit his tendency to self-deception. The agent’s

forgetfulness is modeled as in B´

enabou (2008) and B´

enabou (2013), which incorporates

anticipatory utility into the model of B´

enabou and Tirole (2002). The contracting frame-

work we adopt represents a further mechanism through which the individual can be

reconciled with reality and is the main contribution of this paper.

In our model, a risk-neutral principal hires a risk-neutral agent for a project. When

the principal offers the contract, the parties are symmetrically informed. If the agent

accepts, he chooses a level of effort that affects the project’s probability of success. After

signing but before choosing his unobservable effort, the agent receives a private signal

about the profitability of the task. A good signal implies a high return in case of success

and a bad signal only an intermediate return. Finally, in case of failure, the return is zero

regardless of type of signal. If the signal is informative about the return from effort, the

agent would benefit from having accurate news. However, because he derives utility

2. Freud (1940, 1957) argues that when events fromthe internal and external world are highly threatening,

people may deny or represstheir implications in order to avoid intolerable anxiety. Denial involves a distortion

of negative experiences so complete that it can block out the memory of the experience altogether (cited in

Taylor, 1989).

3. See Mullainathan (2002) for the case of naive decision makers.