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The Optimality of Simple Contracts: Moral Hazard and Loss Aversion

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Author Info
Fabian Herweg ()
Daniel Müller
Philipp Weinschenk

Additional information is available for the following registered author(s):

Abstract

This paper extends the standard principal-agent model with moral hazard to allow for agents having reference- dependent preferences according to Köszegi and Rabin (2006, 2007). The main finding is that loss aversion leads to fairly simple contracts. In particular, when shifting the focus from standard risk aversion to loss aversion, the optimal contract is a simple bonus contract, i.e. when the agent's performance exceeds a certain threshold he receives a fixed bonus payment. Moreover, if the agent is sufficiently loss averse, it is shown that the first-order approach is not necessarily valid. If this is the case the principal may be unable to fine-tune incentives. Strategic ignorance of information by the principal, however, allows to overcome these problems and may even reduce the cost of implementation.

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File URL: ftp://web.bgse.uni-bonn.de/pub/RePEc/bon/bonedp/bgse17_2008.pdf
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Publisher Info
Paper provided by University of Bonn, Germany in its series Bonn Econ Discussion Papers with number bgse17_2008.

Download reference. The following formats are available: HTML (with abstract), plain text (with abstract), BibTeX, RIS (EndNote, RefMan, ProCite), ReDIF
Length: 46
Date of creation: Sep 2008
Date of revision:
Handle: RePEc:bon:bonedp:bgse17_2008

Contact details of provider:
Postal: Bonn Graduate School of Economics, University of Bonn, Adenauerallee 24 - 26, 53113 Bonn, Germany
Fax: +49 228 73 9221
Web page: http://www.bgse.uni-bonn.de/index.php?id=494

For technical questions regarding this item, or to correct its listing, contact: (Daniel Park).

Related research
Keywords: Agency Model; Moral Hazard; Reference-Dependent Preferences; Loss Aversion;

Find related papers by JEL classification:
D8 - Microeconomics - - Information, Knowledge, and Uncertainty
M1 - Business Administration and Business Economics; Marketing; Accounting - - Business Administration
M5 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics

This paper has been announced in the following NEP Reports:

References listed on IDEAS
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