Optimal incentive contracts under loss aversion and inequity aversion

This paper studies a model of principal-agent problem under loss aversion and inequity aversion. The model analyzes how loss aversion and inequity aversion affect the wage structure in optimal contract design. The results demonstrate that the presence of loss aversion would lead to a set of rising wage levels and that range of wage levels is wider if a principal is more loss averse. In addition, the principal's profit decreases in the principal's degree of loss aversion and in the risk neutral agent's degree of inequity aversion. Nevertheless, the wage growth of risk averse agent will be reduced. Furthermore, the incentive mechanism of non-contractible effort will cause higher wage growth than the one of contractible effort. The increase of realized profit level or the decrease of loss aversion level would lead to too equitable allocations for the risk neutral agent. Under this incentive mechanism, an increase in the risk averse agent's concern for equity will be convergence towards linear sharing rules, while the principal who has more sensitive to the loss may offer much lower wage level.