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Binary payment schemes: Moral hazard and loss aversion

  • Herweg, Fabian
  • Müller, Daniel
  • Weinschenk, Philipp

We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to K o szegi 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.

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Paper provided by University of Munich, Department of Economics in its series Munich Reprints in Economics with number 19450.

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Date of creation: 2010
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Publication status: Published in American Economic Review 5 100(2010): pp. 2451-2477
Handle: RePEc:lmu:muenar:19450
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