Incentive Design under Loss Aversion

David de Meza and David C. Webb

Journal of the European Economic Association, 2007, vol. 5, issue 1, pages 66-92

Abstract: Compensation schemes often reward success but do not penalize failure. Fixed salaries with stock options or bonuses have this feature. Yet the standard principal-agent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, there will be intervals over which pay is insensitive to performance, with the use of carrots but not sticks frequently optimal, especially when risk aversion is low and reference income is endogenous. A further benefit of capping losses, for example through options, is to discourage reckless behavior by executives seeking to resurrect their fortunes. (JEL:F3, F4) (c) 2007 by the European Economic Association.

Date: 2007
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