Salience perception and dominated choices in contracts

Abstract

We apply salience theory to choices over lotteries with multiple dimensions, such as insurance plans with deductibles and premiums, or monetary and non-monetary rewards. We show that salience theory can explain empirically observed dominated choices with large welfare costs to consumers (the selection of dominated insurance plans with low deductibles, dominated energy plans with a cancellation fee, and dominated consumption bundles with free features). The same framework also addresses a basic empirical puzzle in principal–agent problems: the effectiveness of non-monetary incentives over equivalent-in-value monetary incentives. Our results show that these systematically dominated choices documented in markets emerge from the same basic principles of salience perception that generate dominated choices in the laboratory.