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The neural correlates of contractual risk and penalty framing

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  • W. Ekins
  • Andrew Brooks
  • Gregory Berns

Abstract

Standard economic theory treats contractual risk the same as risk experienced in a lottery, but the transfer of risk from principal to agent may change the perception of risk. Previous experimental studies have shown that positive and negative framing affects both gambles and incentive contracts. An agent’s perception of bonus and penalty framing in a contract can determine the extent to which lottery risk and contractual risk are similar. We designed an experiment that tested the effect of bonus and penalty framed contracts on behavior under an implicit chance of failure. Moreover, we used functional magnetic resonance imaging (fMRI) to observe brain activity while participants viewed the contracts and purchased precautionary measures. We found that the dorsal striatum was more active during a penalty frame than a bonus frame. The study suggests that risk experienced by agents in an incentive contract is not comparable to risk experienced as a lottery. Copyright Springer Science+Business Media New York 2014

Suggested Citation

  • W. Ekins & Andrew Brooks & Gregory Berns, 2014. "The neural correlates of contractual risk and penalty framing," Journal of Risk and Uncertainty, Springer, vol. 49(2), pages 125-140, October.
    • Handle: RePEc:kap:jrisku:v:49:y:2014:i:2:p:125-140
    DOI: 10.1007/s11166-014-9199-7
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    References listed on IDEAS

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    1. Simon Gervais & J. B. Heaton & Terrance Odean, 2011. "Overconfidence, Compensation Contracts, and Capital Budgeting," Journal of Finance, American Finance Association, vol. 66(5), pages 1735-1777, October.
    2. Allen, Douglas W & Lueck, Dean, 1995. "Risk Preferences and the Economics of Contracts," American Economic Review, American Economic Association, vol. 85(2), pages 447-451, May.
    3. Edward P. Lazear, 1991. "Labor Economics and the Psychology of Organizations," Journal of Economic Perspectives, American Economic Association, vol. 5(2), pages 89-110, Spring.
    4. Luft, Joan, 1994. "Bonus and penalty incentives contract choice by employees," Journal of Accounting and Economics, Elsevier, vol. 18(2), pages 181-206, September.
    5. Tracy R. Lewis, 1980. "Bonus and Penalties in Incentive Contracting," Bell Journal of Economics, The RAND Corporation, vol. 11(1), pages 292-301, Spring.
    6. James R. Frederickson & William Waller, 2005. "Carrot or Stick? Contract Frame and Use of Decision‐Influencing Information in a Principal‐Agent Setting," Journal of Accounting Research, Wiley Blackwell, vol. 43(5), pages 709-733, December.
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    Cited by:

    1. Carlos Alós-Ferrer & Alexander Jaudas & Alexander Ritschel, 2021. "Effortful Bayesian updating: A pupil-dilation study," Journal of Risk and Uncertainty, Springer, vol. 63(1), pages 81-102, August.

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    More about this item

    Keywords

    Risk; Incentive contracts; Framing effects; fMRI; Striatum; C91; D81; D86; D87;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • D87 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Neuroeconomics

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