Loss Aversion and Reference Points in Contracts
AbstractLoss 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 InfoPaper provided by Cornell University, Department of Applied Economics and Management in its series Working Papers with number 127073.
Date of creation: 2005
Date of revision:
Risk and Uncertainty; L14; D81; D21; D82;
Other versions of this item:
- Just, David R. & Wu, Steven Y., 2005. "Loss Aversion and Reference Points in Contracts," SCC-76 Meeting, March 31-April 2, 2005, Myrtle Beach, SC 28727, SCC-76: Economics and Management of Risk in Agriculture and Natural Resources.
- L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
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- 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.
- Katharina Hilken & Kris De Jaegher & Marc Jegers, 2013. "Strategic Framing in Contracts," Working Papers 13-04, Utrecht School of Economics.
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