Loss Aversion, Moral Hazard, and Stochastic Contracts
Abstract: I examine whether stochastic contracts benefit the principal in the setting of moral hazard and loss aversion. Incorporating that the agent is expectation-based loss averse and allowing the principal to add noise to performance signals, I find that stochastic contracts reduce the principal's implementation cost in comparison to deterministic contracts. The optimal stochastic contract pays a high wage whenever good signals are realized and with a positive probability when bad signals are realized. Surprisingly, if performance signals are highly informative about the agent's action, stochastic contracts strictly dominate the optimal deterministic contract for almost any degree of loss aversion. 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.
