Loss Aversion, Moral Hazard, and Stochastic Contracts

Hoa Ho

Managerial and Decision Economics, 2025, vol. 46, issue 3, 1677-1685

Abstract: I examine whether stochastic contracts benefit the principal under moral hazard and loss aversion. Incorporating the agent's expectation‐based loss aversion and allowing for stochastic contracts, I find that stochastic contracts reduce the principal's cost as compared with deterministic contracts. The optimal stochastic contract pays a high wage not only when good signals are realized but also with a positive probability after the realization of bad signals. The findings have an important implication for designing contracts for loss‐averse agents: the principal should insure the agent against wage uncertainty by employing stochastic contracts that increase the probability of a high wage.

Date: 2025
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https://doi.org/10.1002/mde.4459

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Persistent link: https://EconPapers.repec.org/RePEc:wly:mgtdec:v:46:y:2025:i:3:p:1677-1685

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