Preference-driven contract design: How education alters risk, patience, and effort in incentive schemes

Performance-contingent pay raises productivity, yet in the German Socio-Economic Panel (SOEP) only about 16% of workers report receiving performance pay, with the incidence being roughly seven percentage points higher among university graduates than among non-graduates. This coexistence of low aggregate take-up and a strong skill gradient is puzzling. This paper accounts for these twin facts with a principal-agent model in which the entire preference vector-risk aversion, probability weighting, time discounting, and effort cost-varies systematically with schooling. Endogenizing preferences yields two predictions: (i) optimal incentive slopes and induced effort increase with education-linked preferences; (ii) the productivity threshold for accepting performance pay falls with schooling, while heterogeneity in tastes keeps worker participation incomplete. A light calibration guided by documented schooling gradients reproduces modest overall incidence alongside a pronounced skill gradient. The key novelty is to treat the preference vector as an endogenous state variable that enters both sides of the principal-agent problem, shaping the optimisation problems of both the firm and the worker rather than being taken as a fixed primitive.