Incentive Design for Reference-Dependent Preferences

I investigate the optimal design of incentives when the agent exhibits reference dependence. The theoretical framework of this paper incorporates the most prominent characterizations of reference-dependent preferences and integrates the most frequently used reference point rules. I find that, regardless of the chosen preference specification and reference point rule, the optimal contract must include a bonus. This contract shape allows the principal to profitably exploit the agent’s irrationalities of loss aversion and diminishing sensitivity to extract output. This paper provides a rationale for incentive schemes including bonuses grounded in preference