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Binary Payment Schemes: Moral Hazard and Loss Aversion

  • Fabian Herweg


    (University of Bonn)

  • Daniel Müller


    (University of Bonn)

  • Philipp Weinschenk


    (Max Planck Institute for Research on Collective Goods)

We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to Köszegi 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 Max Planck Institute for Research on Collective Goods in its series Working Paper Series of the Max Planck Institute for Research on Collective Goods with number 2010_38.

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Date of creation: Sep 2010
Date of revision:
Handle: RePEc:mpg:wpaper:2010_38
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