Overcon fi dence , Morale and Wage - Setting Policies ∗

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.