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Loss Aversion and Reference Points in Contracts

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  • Just, David R.
  • Wu, Steven Y.

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.

Suggested Citation

  • Just, David R. & Wu, Steven Y., 2005. "Loss Aversion and Reference Points in Contracts," SCC-76 Meeting, 2005, March 31-April 2, Myrtle Beach, South Carolina 28727, SCC-76: Economics and Management of Risk in Agriculture and Natural Resources.
    • Handle: RePEc:ags:sccfmb:28727
    DOI: 10.22004/ag.econ.28727
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    References listed on IDEAS

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    Cited by:

    1. Jonathan de Quidt, 2018. "Your Loss Is My Gain: A Recruitment Experiment with Framed Incentives," Journal of the European Economic Association, European Economic Association, vol. 16(2), pages 522-559.
    2. de Quidt, Jonathan, 2014. "Your loss is my gain: a recruitment experiment with framed incentives," LSE Research Online Documents on Economics 58208, London School of Economics and Political Science, LSE Library.
    3. Bellemare, Marc F. & Barrett, Christopher B. & Osterloh, Sharon M., 2005. "Household-Level Livestock Marketing Behavior Among Northern Kenyan and Southern Ethiopian Pastoralists," Working Papers 14749, Cornell University, Department of Applied Economics and Management.
    4. K. Hilken & K.J.M. De Jaegher & M. Jegers, 2013. "Strategic Framing in Contracts," Working Papers 13-04, Utrecht School of Economics.

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    More about this item

    Keywords

    Risk and Uncertainty;

    JEL classification:

    • L14 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Transactional Relationships; Contracts and Reputation
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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