Overconfidence, Morale and Wage-Setting Policies ∗

Abstract

Psychologists have consistently documented people’s tendency to be overconfident about their own ability. We interpret workers ’ confidence in their own skills as their morale, and investigate the implication of worker overconfidence on the firm’s optimal wage-setting policies. In our model, a wage contract both provides incentives and conveys to the worker the firm’s opinion about her ability, hence affects her morale. We provide conditions for the non-differentiation wage policy − the firm offers the same contract to all workers irrespective of its perceptions about their relative abilities − to be superior to the differentiation wage policy. In numerical examples, we show that, first, worker overconfidence is a necessary condition for the firm to prefer no wage differentiation so as to preserve some workers ’ morale; second, the non-differentiation wage policy will itself breed more worker overconfidence, thus “overconfidence begets overconfidence;” and third, wage compression is more likely when aggregate productivity is low.