Binary Payment Schemes: Moral Hazard and Loss Aversion
48 Pages Posted: 21 Sep 2010 Last revised: 9 Oct 2010
Date Written: September 2010
Abstract
We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to Köszegi and Rabin (2006, 2007). The optimal contract is a binary payment scheme even for a rich performance measure, where standard preferences predict a fully contingent contract. The logic is that, due to the stochastic reference point, increasing the number of different wages reduces the agent’s expected utility without providing strong additional incentives. Moreover, for diminutive occurrence probabilities for all signals the agent is rewarded with the fixed bonus if his performance exceeds a certain threshold.
JEL Classification: D82, M12, M52
Suggested Citation: Suggested Citation
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