This paper addresses two major topics concerning the role of expectations in the formation of reference points. First, we show that when expectations are present, they have a significant impact on reference point formation. Second, we find that decision-makers employ expected values when forming reference points (integrated mechanism) as opposed to single possible outcomes (segregated mechanism). Despite the importance of reference points in prospect theory, to date, there is no standard method of examining these. We develop a new experimental design that employs an indirect approach and extends an existing direct approach. Our findings are consistent across the two approaches.

Indirect reciprocity has been proposed to explain prosocial behavior among strangers, whereby the prosocial act is returned by a third party. However, what happens if the prosocial act cannot be observed by the third party? Here, we examine whether empathy serves as a clue for prosociality and whether people are more generous toward more empathetic people. In a laboratory study, we measured prosocial behavior as the amount sent in the dictator game and empathy based on the Interpersonal Reactivity Index (IRI). By using an incentivized task, we find that people believe that more empathetic participants send more money in the dictator game. Thus, people see empathy as a clue for prosocial behavior. Furthermore, in a second dictator game, participants indirectly reciprocate by sending more money to more empathetic recipients. Therefore, we suggest that empathy can replace a reputation derived from observable prosocial behavior in triggering indirect reciprocity.

We suggest a parsimonious dynamic agency model in which workers have status concerns. A firm is a promotion hierarchy in which a worker's status depends on past performance. We investigate the optimality of two types of promotion hierarchies: (i) standard promotion practices, where agents have a job guarantee, and (ii) "up-orout", in which agents are fired when unsuccessful. We show that up-or-out is optimal if success is difficult to achieve. When success is less hard to achieve, standard promotion practices are optimal provided the payoffs associated with success are moderate. Otherwise, up-or-out is, again, optimal.

We examine the optimal size of risk pools with moral hazard. In risk pools, the effective share of the own loss borne is the sum of the direct share (the retention rate) and the indirect share borne as residual claimant. In a model with identical individuals with mixed risk‐averse utility functions, we show that the effective share required to implement a specific effort increases in the pool size. This is a downside of larger pools as it, ceteris paribus, reduces risk sharing. However, we find that the benefit from diversifying the risk in larger pools always outweighs the downside of a higher effective share. We conclude that, absent transaction costs, the optimal pool size converges to infinity. In our basic model, we restrict attention to binary effort levels, but we show that our results extend to a model with continuous effort choice.

Stakeholder honesty is highly important for managers, for instance, in decisions involving hiring. Due to reciprocity, stakeholders are more likely to be honest if the managers act honestly themselves. However, external stakeholders often cannot observe managers’ actions and instead have to rely on signals. This article examines the effects of two signals—a manager’s owner family membership and religious affiliation—on stakeholder honesty. By conducting an economic experiment and a survey, we find that stakeholders behave more honestly toward family managers compared to nonfamily managers. This effect is reinforced if the family manager is presented as religious.