Does Overconfidence Impede an Innovation Chain? Implications for Investor Operations

Abstract

Overconfidence is a prevalent cognitive bias and exists practically in innovation investment and operations, while it is widely acknowledged to be detrimental to innovation. This study examines an innovation chain consisting of an investor and an overconfident innovator, wherein the investor is committed to supporting the innovator with capital and resources, and the innovator is responsible for the products’ innovation and production. Specifically, we focus on three types of innovators that exsit in practice, namely, completely rational innovator, probabilistically overconfident innovator, and market-overconfident innovator. We then explore the impact of overconfidence on both the investor and innovator. We find that the innovation effort level of the innovator is not correlated with the degree of probabilistic overconfidence but increases monotonically with the degree of market overconfidence. Counterintuitively, when the degree of market overconfidence is weak, such overconfidence strengthens the incentives for both the investor and the innovator to invest and innovate; our results suggest that appropriate market overconfidence may improve the investor's profit, whereas probabilistic overconfidence consistently reduces it. Both probabilistic overconfidence and market overconfidence are detrimental to the innovator. Overall, overconfidence undermines the performance of the entire innovation chain. Furthermore, our study extends to the analysis where the investor cannot know the innovator's type, and reveals that the main results derived in the basic model still hold.