Incentive Contracts for Overoptimistic Managers

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.