Contracting Probability Distortions

Victor González-Jimenez

I introduce a contract designed to take advantage of the regularity that individuals distort probabilities. With this contract, the principal could activate the probability distortions that are inherent in the agent and use these distortions to incentivize the agent to perform a relevant task. This is because in the contract, the principal could choose the probability that the agent’s compensation depends on his own performance on the task. Distortions of such probability generate higher or lower motivation to perform the task. A theoretical framework and an experiment demonstrate that the proposed contract yields higher output than a traditional contract when both contracts o?er similar monetary incentives. However, the probability specified by the principal is critical to achieving this result. Small probabilities yield higher levels of performance, whereas medium or high probabilities yield no performance differences between the contracts. The degree to which individuals overweight small probabilities explains these findings.

Department of Economics
No. of pages
Publication date
Austrian Fields of Science 2012
502045 Behavioural economics, 502002 Labour economics, 502021 Microeconomics, 501011 Cognitive psychology
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