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Loss Aversion, Moral Hazard, and Stochastic Contracts

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  • Hoa Ho

Abstract

I examine whether stochastic contracts benefit the principal under moral hazard and loss aversion. Incorporating the agent's expectation‐based loss aversion and allowing for stochastic contracts, I find that stochastic contracts reduce the principal's cost as compared with deterministic contracts. The optimal stochastic contract pays a high wage not only when good signals are realized but also with a positive probability after the realization of bad signals. The findings have an important implication for designing contracts for loss‐averse agents: the principal should insure the agent against wage uncertainty by employing stochastic contracts that increase the probability of a high wage.

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  • Hoa Ho, 2025. "Loss Aversion, Moral Hazard, and Stochastic Contracts," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 46(3), pages 1677-1685, April.
    • Handle: RePEc:wly:mgtdec:v:46:y:2025:i:3:p:1677-1685
    DOI: 10.1002/mde.4459
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