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Loss Aversion and Reference Points in Contracts

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  • Just, David R.
  • Wu, Steve

Abstract

Loss aversion has become the dominant alternative to expected utility theory for modeling choice under uncertainty. The setting of the base payment in contracts provides an interesting application of referenced based decision theory. The impact of loss aversion on contract structure depends critically on whether reservation opportunities (outside options) are evaluated with respect to the reference point implied in the contract. We show that when reservation opportunities are independent of the reference point, reward contracts are optimal. However, when reservation opportunities are evaluated against the reference point, then penalty contracts are more efficient.

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Bibliographic Info

Paper provided by Cornell University, Department of Applied Economics and Management in its series Working Papers with number 127073.

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Date of creation: 2005
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Handle: RePEc:ags:cudawp:127073

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Related research

Keywords: Risk and Uncertainty; L14; D81; D21; D82;

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  1. Hueth, Brent & Ligon, Ethan, 2003. "On the Efficacy of Contractual Provisions for Processing Tomatoes," 2003 Annual meeting, July 27-30, Montreal, Canada 21990, American Agricultural Economics Association (New Name 2008: Agricultural and Applied Economics Association).
  2. Brent Hueth & Ethan Ligon, 2002. "Estimation of an efficient tomato contract," European Review of Agricultural Economics, Foundation for the European Review of Agricultural Economics, vol. 29(2), pages 237-253, June.
  3. Innes, Robert D., 1990. "Limited liability and incentive contracting with ex-ante action choices," Journal of Economic Theory, Elsevier, vol. 52(1), pages 45-67, October.
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Cited by:
  1. Jonathan de Quidt, 2014. "Your Loss Is My Gain: A Recruitment Experiment With Framed Incentives," STICERD - Economic Organisation and Public Policy Discussion Papers Series 52, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  2. Katharina Hilken & Kris De Jaegher & Marc Jegers, 2013. "Strategic Framing in Contracts," Working Papers 13-04, Utrecht School of Economics.

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