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.
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 (Citation2010) 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 (Citation1992) 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.