30 Pages Posted: 13 Nov 2013 Last revised: 27 Sep 2016
Date Written: June 19, 2016
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
Suggested Citation: Suggested Citation
Brooks, Richard R. W. and Stremitzer, Alexander and Tontrup, Stephan, Stretch It But Don't Break It: The Hidden Cost of Contract Framing (June 19, 2016). UCLA School of Law, Law-Econ Research Paper No. 13-22. Available at SSRN: https://ssrn.com/abstract=2353733 or http://dx.doi.org/10.2139/ssrn.2353733