Strategically Influencing Expectations: Endogenous Reference Points in Contracts

In this principal-agent moral hazard model, the agent's reference point is determined by rational expectations (Köszegi & Rabin, 2006). The principal (she) takes into account that by designing the incentive contract for the agent (he), the stochastic reference point of the agent is determined. Based on the incentive contract, he agent expects to provide some effort, which he will follow through in a personal equilibrium (PE). As several personal equilibria might exist, the principal, being able to strategically influence the expectations of the agent can choose the PE which is most beneficial for her. This leads to high effort for lower payments compared to the standard model.