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Incentive design under loss aversion

de Meza, David and Webb, David C. (2006) Incentive design under loss aversion. Discussion paper, 571. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Abstract

Compensation schemes often reward success but do not penalize failure. Fixed salaries with stock options or bonuses have this feature. Yet the standard principal–agent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, there will be intervals over which pay is insensitive to performance, with the use of carrots but not sticks is frequently optimal, especially when risk aversion is low and reference income is endogenous. A further benefit of capping losses, for example through options, is to discourage reckless behavior by executives seeking to resurrect their fortunes.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2006 The Authors
Library of Congress subject classification: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
Journal of Economic Literature Classification System: F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance
F - International Economics > F3 - International Finance
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Rights: http://www.lse.ac.uk/library/usingTheLibrary/academicSupport/OA/depositYourResearch.aspx
Identification Number: 571
Date Deposited: 19 Jul 2009 18:51
URL: http://eprints.lse.ac.uk/24523/

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