Stretch It But Don't Break It: The Hidden Cost of Contract Framing

Abstract

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.

Keywords: contracts, framing effects, loss aversion, prospect theory, expressed thresholds, worker productivity

JEL Classification: C91, D02, J33, K12