The Effect of Loss Aversion on the Principal-Agent Problem

Abstract

In the setting of the principal-agent problem, loss aversion presents the opportunity for the principal to use the fear of loss along with the desire for gain to motivate the agent. This paper uses the principal-agent framework to compare the relative effectiveness of desire for gain and fear of loss as motivators of human behavior. Specifically, the paper studies how a loss averse agent with reference-dependent preferences responds to compensation and incentives provided in a single-period setting. In the single-period contract, when the agent's actions are not observable by the principal (moral hazard), the paper shows how the presence of loss aversion increases the cost to the principal and leads to simple contracts in contrast with the more complex contracts of classical principal-agent theory. Further, the paper shows that, how the agent discounts future utility affects the amount of effort he exerts. In the process, the paper proves that, under reasonable assumptions, the agent will exert the most effort under a malus contract, less effort under a hybrid bonus-malus contract and the least effort under a bonus contract.