FRAMING OF INCENTIVES AND EFFORT PROVISION

A prospect theory model combining loss aversion and diminishing sensitivity predicts that the link between incentives framing and effort is ambiguous: small penalties yield higher effort, but isomorphic contracts with large penalties decrease effort. We conduct two experiments (a framed field and a conventional lab experiment) in which economically equivalent contracts are framed as menus of either (i) bonuses, (ii) penalties, or (iii) bonuses and penalties. The experimental results confirm the main intuition of the model as subjects performed best when bonuses and penalties are combined. A follow‐up lottery experiment confirms that both loss aversion and diminishing sensitivity influenced the performance.