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How does product market competition influence whether CEOs with greater or lower levels of overconfidence are hired and whether CEOs overinvest in innovation? In a Cournot model in which firms hire a CEO to take charge of research and development (R&D) investment and production decisions, this paper shows that CEO overconfidence and overinvestment can be explained as an equilibrium outcome. More importantly, the intensity of product market competition and the equilibrium CEO overconfidence level (and R&D investment) exhibit an inverted U-shaped relationship. As the product market tends toward perfect competition, all firms hire a realistic CEO and do not overinvest.

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In the wake of recent financial crises and corporate failures, chief executive officers (CEOs) are often blamed for their overconfidence leading to earnings manipulation and excessive risks. Why is it then that these overconfident CEOs obtain job offers in the first place? This paper presents a novel explanation for the co-existence of CEO overconfidence and earnings manipulation observed in practice. In an agency model with an external capital market, I identify two potential reasons for a board to hire an overconfident CEO and design a contract that accommodates earnings manipulation: an internal motive, directed at maximizing the ex ante firm value, and an external motive, directed at enhancing the interim market valuation of the firm. The flip side, however, is that the firm can be more likely to become insolvent and bear greater risks of bankruptcy. Some policy implications and limitations are also discussed. JEL Classifications: D86; G34; M41.

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