INCENTIVE DESIGN UNDER LOSS AVERSION | Zendy

Meza David | Zendy; Webb David C. | Zendy

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INCENTIVE DESIGN UNDER LOSS AVERSION

Author(s) -

Meza David,

Webb David C.

Publication year - 2007

Publication title -

journal of the european economic association

Language(s) - English

Resource type - Journals

SCImago Journal Rank - 7.792

H-Index - 93

eISSN - 1542-4774

pISSN - 1542-4766

DOI - 10.1162/jeea.2007.5.1.66

Subject(s) - loss aversion , economics , incentive , risk aversion (psychology) , microeconomics , inequity aversion , compensation (psychology) , stock (firearms) , moral hazard , principal (computer security) , monotonic function , expected utility hypothesis , financial economics , inequality , computer science , mathematical analysis , mathematics , mechanical engineering , psychology , psychoanalysis , engineering , operating system

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)

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