Binary Payment Schemes: Moral Hazard and Loss Aversion

Fabian Herweg, Daniel Müller, Philipp Weinschenk

American Economic Review · 2010 · Volume 100 · Issue 5

Abstract

We modify the principal-agent model with moral hazard by assuming that the agent is expectation-based loss averse according to Kőszegi 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. (JEL D82, D86, J41, M52, M12)

Keywords

Asymmetric and Private Information, Economics of Contract: Theory, Labor Contracts, Personnel Management, Executive Compensation, Personnel Economics: Compensation and Compensation Methods and Their Effects

Enable JavaScript for citation tools and additional paper interactions.