The psychology of prizes: Loss aversion and optimal tournament rewards

TL;DR

This paper examines how loss aversion influences optimal prize structures in tournaments, showing that equitable rewards can mitigate psychological costs and enhance effort, especially when agents are loss averse.

Contribution

It introduces a model analyzing the impact of loss aversion on prize allocation, revealing conditions where equitable prizes improve effort and outcomes.

Findings

Equitable prizes reduce psychological costs for loss averse agents.

Loss aversion can increase effort if prizes are sufficiently fair.

Optimal prizes tend to be more equitable under loss aversion.

Abstract

We study the optimal allocation of prizes in rank-order tournaments with loss averse agents. Prize sharing becomes increasingly optimal with loss aversion because more equitable prizes reduce the marginal psychological cost of anticipated losses. Furthermore, loss aversion can boost effort if prizes are sufficiently equitable, but otherwise effort declines with loss aversion. Overall, these results give credence to more equitable allocations of competitive rewards. A win-win scenario is where optimal prizes are equitable even under loss neutrality, in which case the principal benefits from agents' loss aversion.