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American Economic Review: Vol. 100 No. 5 (December 2010)


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Binary Payment Schemes: Moral Hazard and Loss Aversion

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Herweg, Fabian, Daniel Muller, 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


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)

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Herweg, Fabian (U Bonn)
Muller, Daniel (U Bonn)
Weinschenk, Philipp (U Bonn and Max Planck Institute for Research on Collective Goods, Bonn)

JEL Classifications

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

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