ABSTRACT
Which policies, contracts, or rules most effectively incentivize behaviors in a particular direction? Incentives can take the form of rewards for desired behaviors (as subsidies or bonuses), or punishments for undesired behaviors (as taxes or fines). From the perspective of a standard decision maker, a reward for doing an activity has the same incentive effect as an equivalent punishment for not doing the activity. But when individuals are loss averse, equivalent rewards and punishments no longer share the same incentive effects. A loss averse individual is predicted to exert greater effort to avoid a punishment than to achieve a reward. This chapter explores how this prediction generates novel insights for the design of public policy and private contracts. Policy examples include incentives for reusable shopping bags and teacher instructional quality. The consequences of loss aversion for profit maximization are explored in the final two sections, with applications to worker contracts and auction design.
