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  4. December 2010
  5. Binary Payment Schemes: Moral Hazard and Loss Aversion

American Economic Review

ISSN 0002-8282 (Print) | ISSN 1944-7981 (Online)

Binary Payment Schemes: Moral Hazard and Loss Aversion

  • Fabian Herweg
  • Daniel Müller
  • Philipp Weinschenk
American Economic Review
vol. 100, no. 5, December 2010
(pp. 2451–77)
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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)

Citation

Herweg, Fabian, Daniel Müller, and Philipp Weinschenk. 2010. "Binary Payment Schemes: Moral Hazard and Loss Aversion." American Economic Review 100 (5): 2451–77. DOI: 10.1257/aer.100.5.2451

Additional Materials

JEL Classification

  • D82 Asymmetric and Private Information
  • D86 Economics of Contract: Theory
  • J41 Labor Contracts
  • M12 Personnel Management; Executive Compensation
  • M52 Personnel Economics: Compensation and Compensation Methods and Their Effects