Screening, Overconfidence, and Competition's Effect on Market Efficiency

This paper examines the relationship between competition and efficiency in a market in which incentive contracts are offered to overconfident agents. The context is a labor market in which worker effort is not observed by firms (moral hazard), workers have private information about their productivity (adverse selection), and workers overestimate their productivity (overconfidence). Firms solve an optimal contracting problem that involves trade-offs between efficiency, rent-extraction, exploitation of overconfidence, and attracting workers. Regardless of the degree of competition between firms, overconfidence promotes overincentivization of worker effort. In equilibrium, the effort of high types is inefficiently high and independent of the degree of competition, while low-type effort is non-monotonic in the degree of competition and may be at, above, or below the efficient level. Social welfare is also non-monotonic in the degree of competition but always below the first-best. Monopsony maximizes social welfare if low types are common enough, while an intermediate degree of competition does otherwise