A Critical Evaluation of Loss Aversion as the Determinate of Effort in Compensation Framing

A robust finding in managerial accounting research is that participants prefer economically equivalent contracts framed as bonuses to penalties. Another finding is that participants put forth more effort when facing penalty contracts than equivalent bonus contracts. Both results are commonly described as due to loss aversion, an integral portion of Prospect Theory. We test whether loss aversion is correlated with higher effort in an experiment with two parts. In the first part, we elicit individual participants' loss aversion using two measures. In the second part of the experiment, participants choose costly efforts to increase the likelihood of high versus low state-contingent payoffs framed as bonuses or penalties. We find significant differences in the effort chosen between treatments: participants put in significantly more effort when facing penalty contracts. However, we find no evidence that either measure's degree of loss aversion correlates with effort choices as predicted by Prospect Theory. We find that only a quarter of participants are consistent with the Prospect Theory, and for those, we see little evidence of the commonly cited features of loss aversion. While the most cited reason for framing incentives changing participant behavior is loss aversion, our results suggest that this reason is falsified. While the results from prior studies are replicable, the untested underlying mechanism is not loss aversion.