Stretch It But Don't Break It: The Hidden Risk of Contract Framing
Richard R. W. Brooks
Yale University - Law School
UCLA School of Law
New York University School of Law
June 3, 2014
UCLA School of Law, Law-Econ Research Paper No. 13-22
Recent research suggests that loss framed contracts are an effective instrument for principals to maximize the effort of their agents. Framing effects arise from defining thresholds that vary the salience of losses and gains while preserving payoff equivalence of the underlying contract. While under Prospect Theory a loss frame should lead to more effort we show that contract thresholds also exert a suggestive effect on performance that can trump the impact of loss aversion. Loss framing therefore carries a risk. As agents focus their effort choice on the expressed thresholds, poorly selected thresholds reduce effort and the principal might prefer offering a contract that does not impose a threshold at all. On the other hand, imposing demanding thresholds may push effort beyond levels predicted by Prospect Theory.
Number of Pages in PDF File: 24
Keywords: contracts, framing effects, loss aversion, prospect theory, expressed thresholds, worker productivity
JEL Classification: C91, D02, J33, K12
Date posted: November 13, 2013 ; Last revised: July 23, 2014
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