Advanced Search
MyIDEAS: Login to save this paper or follow this series

The Optimality of Simple Contracts: Moral Hazard and Loss Aversion

Contents:

Author Info

  • Fabian Herweg

    ()

  • Daniel Müller
  • Philipp Weinschenk

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.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.wiwi.uni-bonn.de/bgsepapers/bonedp/bgse17_2008.pdf
Download Restriction: no

Bibliographic Info

Paper provided by University of Bonn, Germany in its series Bonn Econ Discussion Papers with number bgse17_2008.

as in new window
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 6884
Web page: http://www.bgse.uni-bonn.de

Related research

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

Find related papers by JEL classification:

This paper has been announced in the following NEP Reports:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
  2. Englmaier, Florian & Wambach, Achim, 2005. "Optimal Incentive Contracts under Inequity Aversion," IZA Discussion Papers 1643, Institute for the Study of Labor (IZA).
  3. Kim, Son Ku, 1995. "Efficiency of an Information System in an Agency Model," Econometrica, Econometric Society, vol. 63(1), pages 89-102, January.
  4. Bowman, David & Minehart, Deborah & Rabin, Matthew, 1999. "Loss aversion in a consumption-savings model," Journal of Economic Behavior & Organization, Elsevier, vol. 38(2), pages 155-178, February.
  5. Fehr, Ernst & Schmidt, Klaus M., . "A theory of fairness, competition, and cooperation," Chapters in Economics, University of Munich, Department of Economics.
  6. L. Caron & G. Dionne, 1997. "Insurance fraud estimation : more evidence from the Quebec automobile insurance industry," THEMA Working Papers 97-21, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
  7. Canice Prendergast, 1999. "The Provision of Incentives in Firms," Journal of Economic Literature, American Economic Association, vol. 37(1), pages 7-63, March.
  8. Edward P. Lazear & Kathryn L. Shaw, 2007. "Personnel Economics: The Economist's View of Human Resources," NBER Working Papers 13653, National Bureau of Economic Research, Inc.
  9. Haller, Hans, 1985. "The principal-agent problem with a satisficing agent," Journal of Economic Behavior & Organization, Elsevier, vol. 6(4), pages 359-379, December.
  10. Botond Koszegi & Matthew Rabin, 2004. "A Model of Reference-Dependent Preferences," Method and Hist of Econ Thought 0407001, EconWPA.
  11. Dominique Demougin & Claude Fluet, 1996. "Mechanism Sufficient Statistic in the Risk-Neutral Agency Problem," Cahiers de recherche du Département des sciences économiques, UQAM 9602, Université du Québec à Montréal, Département des sciences économiques.
  12. Pierre-André Chiappori & Bruno Jullien & Bernard Salanié & François Salanié, 2002. "Asymmetric Information in Insurance : General Testable Implications," Working Papers 2002-42, Centre de Recherche en Economie et Statistique.
  13. Gary S. Becker & George J. Stigler, 1974. "Law Enforcement, Malfeasance, and Compensation of Enforcers," The Journal of Legal Studies, University of Chicago Press, vol. 3(1), pages 1-18, January.
  14. Georges Dionne & Robert Gagné, 2001. "Deductible Contracts Against Fraudulent Claims: Evidence From Automobile Insurance," The Review of Economics and Statistics, MIT Press, vol. 83(2), pages 290-301, May.
  15. Bentley W. MacLeod, 2003. "Optimal Contracting with Subjective Evaluation," American Economic Review, American Economic Association, vol. 93(1), pages 216-240, March.
  16. Dittmann, Ingolf & Maug, Ernst & Spalt, Oliver, 2007. "Executive Stock Options when Managers are Loss-Averse," Sonderforschungsbereich 504 Publications 07-36, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
  17. Ted O'Donoghue & Matthew Rabin, 1997. "Incentives for Procrastinators," Discussion Papers 1181, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  18. Tversky, Amos & Kahneman, Daniel, 1991. "Loss Aversion in Riskless Choice: A Reference-Dependent Model," The Quarterly Journal of Economics, MIT Press, vol. 106(4), pages 1039-61, November.
  19. Thierry Post & Martijn J. van den Assem & Guido Baltussen & Richard H. Thaler, 2008. "Deal or No Deal? Decision Making under Risk in a Large-Payoff Game Show," American Economic Review, American Economic Association, vol. 98(1), pages 38-71, March.
  20. Luis Rayo & Gary S. Becker, 2007. "Evolutionary Efficiency and Happiness," Journal of Political Economy, University of Chicago Press, vol. 115, pages 302-337.
  21. Roland Strausz, . "Deterministic versus Stochastic Mechanisms in Principal--Agent Models," Papers 020, Departmental Working Papers.
  22. David de Meza & David C. Webb, 2007. "Incentive Design under Loss Aversion," Journal of the European Economic Association, MIT Press, vol. 5(1), pages 66-92, 03.
  23. Kohei Daido & Hideshi Itoh, 2007. "The Pygmalion and Galatea Effects: An Agency Model with Reference-Dependent Preferences and Applications to Self-Fulfilling Prophecy," Discussion Paper Series 35, School of Economics, Kwansei Gakuin University, revised Sep 2007.
  24. Gjesdal, Froystein, 1982. "Information and Incentives: The Agency Information Problem," Review of Economic Studies, Wiley Blackwell, vol. 49(3), pages 373-90, July.
  25. Loomes, Graham & Sugden, Robert, 1986. "Disappointment and Dynamic Consistency in Choice under Uncertainty," Review of Economic Studies, Wiley Blackwell, vol. 53(2), pages 271-82, April.
  26. Park, Eun-Soo, 1995. "Incentive Contracting under Limited Liability," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 4(3), pages 477-90, Fall.
  27. Paul Oyer, 1998. "Fiscal Year Ends And Nonlinear Incentive Contracts: The Effect On Business Seasonality," The Quarterly Journal of Economics, MIT Press, vol. 113(1), pages 149-185, February.
  28. Nicholas Barberis & Ming Huang & Tano Santos, 2001. "Prospect Theory And Asset Prices," The Quarterly Journal of Economics, MIT Press, vol. 116(1), pages 1-53, February.
  29. Botond Kőszegi & Paul Heidhues, 2008. "Competition and Price Variation When Consumers Are Loss Averse," American Economic Review, American Economic Association, vol. 98(4), pages 1245-68, September.
  30. Bertsekas, Dimitri P., 1974. "Necessary and sufficient conditions for existence of an optimal portfolio," Journal of Economic Theory, Elsevier, vol. 8(2), pages 235-247, June.
Full references (including those not matched with items on IDEAS)

Citations

Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
as in new window

Cited by:
  1. Katharina Hilken & Kris De Jaegher & Marc Jegers, 2013. "Strategic Framing in Contracts," Working Papers 13-04, Utrecht School of Economics.
  2. Rablen, Matthew D., 2010. "Performance targets, effort and risk-taking," Journal of Economic Psychology, Elsevier, vol. 31(4), pages 687-697, August.

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:bon:bonedp:bgse17_2008. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (BGSE Office).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.