Contract breach with overconfident expectations: Experimental evidence on reference-dependent preferences

Abstract

This study examines the effect of agents' overconfident expectations in their production on their contract breach. Drawing on a reference-dependent framework, we theoretically deduce propositions for compliance to agreements where an agent exhibits overconfidence and loss aversion. We conduct lab experiments with a multiple-stage design and find that overconfident agents are more likely to breach the contract than non-overconfident (unbiased and underconfident) agents. Moreover, overconfident agents breach more often and to a greater extent with increasing loss aversion. In a sub-treatment, we test the impact of a non-deterministic environment where failure to correctly estimate expected payoffs can be hidden. Our findings indicate that agents are more likely to breach in the shock condition but the shock does not affect the extent of breach. Most of our results are in line with the framework. In a treatment, we manipulate agents' overconfidence exogenously and use it as an instrument to establish causality.