Loss Aversion, Moral Hazard, and Stochastic Contracts

ABSTRACT I examine whether stochastic contracts benefit the principal under moral hazard and loss aversion. Incorporating the agent's expectation‐based loss aversion and allowing for stochastic contracts, I find that stochastic contracts reduce the principal's cost as compared with deterministic contracts. The optimal stochastic contract pays a high wage not only when good signals are realized but also with a positive probability after the realization of bad signals. The findings have an important implication for designing contracts for loss‐averse agents: the principal should insure the agent against wage uncertainty by employing stochastic contracts that increase the probability of a high wage.