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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.