Loss Aversion and Reference Points in Contracts

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.


Issue Date:
2005
Publication Type:
Working or Discussion Paper
PURL Identifier:
http://purl.umn.edu/127073
Total Pages:
33
JEL Codes:
L14; D81; D21; D82
Series Statement:
WP
2005-04




 Record created 2017-04-01, last modified 2017-08-26

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