Intertemporal Incentives Under Loss Aversion

This paper studies the intertemporal allocation of incentives in a repeated moral hazard model with reference-dependent preferences as in Kőszegi and Rabin (2009). Besides consumption utility, the agent experiences utility from the change in his beliefs about present and future effort and income. When effort plans are rational, the prospect of being disappointed by the outcome realization equals that of being pleasantly surprised and hence the loss-averse agent is on net hurt by news. In contrast to the prediction with classical preferences but consistent with real-world contracts, if consumption utility is not too concave and news about present income carries sufficiently larger weight in utility than news about future income, a contract setting a current fixed wage is optimal as it minimizes the agent’s compensation for bearing risk. Despite this, I further prove that several standard features of the contract with classical preferences–such as no rents to the agent, conditions to achieve first-best cost and the non-optimality of random contracts–still hold. JEL Classification: D81, D82, D86, J33 ∗I am indebted to my advisors Botond Kőszegi for his immeasurable guidance and support and Matthew Rabin for his thoughtful advice. I am also very grateful to Ben Hermalin and Paul Heidhues for useful comments and discussions. I thank further Pedro Gardete, Iván Kőszegi (mindenekelőtt), Maciej Kotowski, Josh Tasoff and Mike Urbancic and the participants in the Psychology and Economics Seminar at UC Berkeley. †E-mail: [email protected] 1