Reference points and the tradeoff between risk and incentives

T. Dohmen*, A. Non, T. Stolp

*Corresponding author for this work

Research output: Contribution to journalArticleAcademicpeer-review

Abstract

We conduct laboratory experiments to investigate basic predictions of principal-agent theory about the choice of piece rate contracts in the presence of output risk, and provide novel insights that reference dependent preferences affect the tradeoff between risk and incentives. Subjects in our experiments choose their compensation scheme for performing a real-effort task from a menu of linear piece rate and fixed payment combinations. As classical principal-agent models predict, more risk averse individuals choose lower piece rates. However, in contrast to those predictions, we find that low-productivity risk averse workers choose higher piece rates when the riskiness of the environment increases. We hypothesize that reference points affect piece rate choice in risky environments, such that individuals whose expected earnings would exceed (fall below) the reference point in a risk-free environment behave risk averse (seeking) in risky environments. In a second experiment, we exogenously manipulate reference points and confirm this hypothesis.
Original languageEnglish
Pages (from-to)813-831
Number of pages19
JournalJournal of Economic Behavior & Organization
Volume192
DOIs
Publication statusPublished - 1 Dec 2021

JEL classifications

  • d81 - Criteria for Decision-Making under Risk and Uncertainty
  • d91 - "Intertemporal Consumer Choice; Life Cycle Models and Saving"
  • m52 - Personnel Economics: Compensation and Compensation Methods and Their Effects

Keywords

  • Incentive
  • Piece-rate
  • Risk
  • Reference point
  • Laboratory experiment
  • PERFORMANCE PAY
  • DETERMINANTS

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