Contracting Probability Distortions

I introduce a contract designed to take advantage of the regularity that individuals distort probabilities. With this contract, the principal could activate the probability distortions that are inherent in the agent and use these distortions to incentivize the agent to perform a relevant task. This is because in the contract, the principal could choose the probability that the agent’s compensation depends on his own performance on the task. Distortions of such probability generate higher or lower motivation toper form the task. A theoretical framework and an experiment demonstrate that the proposed contract yields higher output than a traditional contract when both contracts o?er similar monetary incentives. However, the probability speci?ed by the principal is critical to achieving this result. Small probabilities yield higher levels of performance, whereas medium or high probabilities yield no performance di?erences between the contracts. The degree to which individuals overweight small probabilities explains these ?ndings.