The Effects of Risk Preference and Loss Aversion on Individual Behavior under Bonus, Penalty, and Combined Contract Frames

Abstract

ABSTRACT: This study examines the effects of risk preference and loss aversion on individual responses to differently framed, yet economically equivalent, incentive contracts. We extend prior research by examining contracts with combinations of bonus, penalty, and clawback incentives. Contracts framed as a combination of bonus and penalty incentives, especially those framed as a clawback, are less attractive to participants than contracts with bonus- or penalty-only incentives. Further, research suggests that individuals' contract preferences are due primarily to loss aversion. We test this conjecture with a new measure of loss aversion. Results indicate that our measure of loss aversion is well calibrated to encompass variation in loss aversion. In addition, participants' loss preferences explain a significant portion of the differences in observed behavior. Importantly, this relation is less significant for clawback contracts, indicating that other preferences may be driving individuals' strong reactions to these contract frames.