The effects of pay regulation when agents are loss averse

ABSTRACT

This article analyses the effects of a regulatory cap on executive pay when the agent is loss averse. I use a principal–agent model with moral hazard in which a principal and an agent bargain over an incentive contract. I show that even a non-binding cap on the agent’s payments can have consequences for the bargained outcome and consequently for the effort the agent exerts.

KEYWORDS:

• Regulatory pay cap
• incentive contract
• moral hazard
• loss aversion
• Nash bargaining solution

JEL CLASSIFICATION:

• C71
• D82
• J33

Acknowdegment

I thank Andreas Roider and Nathan Carroll for valuable comments.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

¹ Moreover, I assume that exerting no effort will yield no output, i. e. .

² Herweg, Müller, and Weinschenk (2010) show that even for a rich performance measure, the optimal contract when agents are loss averse are binary payment schemes.

³ Note that the constraint is the same irrespective of the case of Equation (1).

⁴ The ideal point is also referred to as a utopia point or bliss point.

⁵ Alternatively, Chun and Thomson (1992) propose a bargaining solution where the bargaining partners have a claims point, which is also out of the bargaining set.

⁶ Note that B’ > c’. To see this, write B’= c’ + px with x ≡ c’’p’ – c’p’’ / p’² > 0.