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The Optimality of Simple Contracts: Moral Hazard and Loss Aversion

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  • Herweg, Fabian
  • Müller, Daniel

Abstract

This paper extends the standard principal-agent model with moral hazard to allow for agents having reference- dependent preferences according to Köszegi and Rabin (2006, 2007). The main finding is that loss aversion leads to fairly simple contracts. In particular, when shifting the focus from standard risk aversion to loss aversion, the optimal contract is a simple bonus contract, i.e. when the agent's performance exceeds a certain threshold he receives a fixed bonus payment. Moreover, if the agent is sufficiently loss averse, it is shown that the first-order approach is not necessarily valid. If this is the case the principal may be unable to fine-tune incentives. Strategic ignorance of information by the principal, however, allows to overcome these problems and may even reduce the cost of implementation.

Suggested Citation

  • Herweg, Fabian & Müller, Daniel, 2008. "The Optimality of Simple Contracts: Moral Hazard and Loss Aversion," Bonn Econ Discussion Papers 17/2008, University of Bonn, Bonn Graduate School of Economics (BGSE).
    • Handle: RePEc:zbw:bonedp:172008
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    3. K. Hilken & S. Rosenkranz & K.J.M. De Jaegher & M. Jegers, 2013. "Reference Points, Performance and Ability: A Real Effort Experiment on Framed Incentive Schemes," Working Papers 13-15, Utrecht School of Economics.

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    More about this item

    Keywords

    Agency Model; Moral Hazard; Reference-Dependent Preferences; Loss Aversion;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • M1 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration
    • M5 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics

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