Stretch It but Don’t Break It: The Hidden Cost of Contract Framing

Recent research suggests that loss-framed contracts are an effective instrument for principals to maximize the effort of their agents. Framing effects arise from defining quantity and quality thresholds that vary the salience of losses and gains even while preserving the payoff equivalence of the underlying contract. While plausible interpretations of prospect theory’s loss-aversion insight suggest that a loss frame would lead to more effort, we show that contract thresholds also exert a norm-framing effect on performance that can trump the impact of loss aversion. Loss framing therefore carries a risk: poorly selected thresholds may reduce effort.

Principals may prefer to avoid this risk by offering contracts that impose no threshold at all.