Incentive contracts when agents distort probabilities

I show that stochastic contracts are powerful motivational devices when agents
distort probabilities. Stochastic contracts allow the principal to target probabilities
that, when distorted by the agent, enhance the agent’s motivation to exert effort on the delegated task. This novel source of incentives is absent in traditional contracts. A theoretical framework and an experiment demonstrate that stochastic contracts targeting small probabilities, and thus exposing the agent to a large degree of risk, generate higher performance levels than traditional contracting modalities. A result that contradicts the standard rationale that optimal contracts should feature a tradeoff between insurance and efficiency. This unintuitive finding is attributed to probability distortions caused by likelihood insensitivity—cognitive limitations that restrict the accurate evaluation of probabilities.