Binary Payment Schemes: Moral Hazard and Loss Aversion

48 Pages Posted: 21 Sep 2010 Last revised: 9 Oct 2010

See all articles by Fabian Herweg

Fabian Herweg

University of Bayreuth - Faculty of Law, Business and Economics

Daniel Müller

University of Bonn

Philipp Weinschenk

University of Kaiserslautern; Max Planck Institute for Research on Collective Goods

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

Herweg, Fabian and Müller, Daniel and Weinschenk, Philipp, Binary Payment Schemes: Moral Hazard and Loss Aversion (September 2010). MPI Collective Goods Preprint No. 2010/38, Available at SSRN: https://ssrn.com/abstract=1680268 or http://dx.doi.org/10.2139/ssrn.1680268

Fabian Herweg

University of Bayreuth - Faculty of Law, Business and Economics ( email )

Universitätsstraße 30
Bayreuth, 95447
Germany

Daniel Müller

University of Bonn ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

Philipp Weinschenk (Contact Author)

University of Kaiserslautern ( email )

Paul-Ehrlich-Straße 14
Kaiserslautern, D-67663
Germany

HOME PAGE: http://https://vwl-mikro.wiwi.uni-kl.de/team/prof-dr-philipp-weinschenk/

Max Planck Institute for Research on Collective Goods ( email )

Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany

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