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Binary Payment Schemes: Moral Hazard and Loss Aversion

  • Fabian Herweg
  • Daniel Muller
  • Philipp Weinschenk

We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to Koszegi and Rabin (2006, 2007). The optimal contract is a binary payment scheme even for a rich performance measure, where standard preferences predict a fully contingent contract. The logic is that, due to the stochastic reference point, increasing the number of different wages reduces the agent's expected utility without providing strong additional incentives. Moreover, for diminutive occurrence probabilities for all signals the agent is rewarded with the fixed bonus if his performance exceeds a certain threshold. (JEL D82, D86, J41, M52, M12)

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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 100 (2010)
Issue (Month): 5 (December)
Pages: 2451-77

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Handle: RePEc:aea:aecrev:v:100:y:2010:i:5:p:2451-77
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