Loss Aversion, Moral Hazard, and Stochastic Contracts

Ho, Hoa (2025): Loss Aversion, Moral Hazard, and Stochastic Contracts. In: Managerial and Decision Economics, Vol. 46, No. 3: pp. 1677-1685

Abstract

I examine whether stochastic contracts benefit the principal under moral hazard and loss aversion. Incorporating the agent's expectation-based loss aversion and allowing for stochastic contracts, I find that stochastic contracts reduce the principal's cost as compared with deterministic contracts. The optimal stochastic contract pays a high wage not only when good signals are realized but also with a positive probability after the realization of bad signals. The findings have an important implication for designing contracts for loss-averse agents: the principal should insure the agent against wage uncertainty by employing stochastic contracts that increase the probability of a high wage.

• Item Type: Journal article
• Faculties: Munich School of Management > Institute for Accounting and Control
• Subjects: 300 Social sciences > 330 Economics
• ISSN: 0143-6570
• Language: English