Incentive Compensation Based on Managerial Ability and Overconfidence Bias

The traditional principal agent relationship is studied under the agent's rationality and ability homogeneity. In fact, agent's behaviors are affected by their psychological bias, and there exists heterogeneity in the agent's abilities, which can affect the firm output. Thus, the agent's ability and overconfidence bias are introduced into the principal agent relationship. Through the optimal contracts and the relative static analysis, it is shown that different contract designs can affect different ability accumulation and bring out different output. Overconfidence bias can align agent's actions to the interests of principal and can motivate agents' human capital accumulation. Economic stimulus measures are needed to boost managers' confidence and entrepreneur long term development.