Loss Aversion and Reference Points in Contracts

David R. Just and Steven Wu ()

No 28727, SCC-76 Meeting, March 31-April 2, 2005, Myrtle Beach, SC from SCC-76: Economics and Management of Risk in Agriculture and Natural Resources

Abstract: Loss aversion has become the dominant alternative to expected utility theory for modeling choice under uncertainty. The setting of the base payment in contracts provides an interesting application of referenced based decision theory. The impact of loss aversion on contract structure depends critically on whether reservation opportunities (outside options) are evaluated with respect to the reference point implied in the contract. We show that when reservation opportunities are independent of the reference point, reward contracts are optimal. However, when reservation opportunities are evaluated against the reference point, then penalty contracts are more efficient.

Keywords: Risk and Uncertainty; L14; D81; D21; D82 (search for similar items in EconPapers)
Date: 2005
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