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Incentive design under loss aversion

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  • de Meza, David
  • Webb, David C.

Abstract

Compensation schemes often reward success but do not penalize failure. Fixed salaries with stock options or bonuses have this feature. Yet the standard principal–agent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, there will be intervals over which pay is insensitive to performance, with the use of carrots but not sticks is frequently optimal, especially when risk aversion is low and reference income is endogenous. A further benefit of capping losses, for example through options, is to discourage reckless behavior by executives seeking to resurrect their fortunes.

Suggested Citation

  • de Meza, David & Webb, David C., 2006. "Incentive design under loss aversion," LSE Research Online Documents on Economics 24523, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:24523
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    JEL classification:

    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • F3 - International Economics - - International Finance

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