with Reference-Dependent Preferences

We attempt to formulate and explain two types of self-fulfilling prophecy, called the Pygmalion effect (if a supervisor thinks her sub-ordinates will succeed, they are more likely to succeed) and the Galatea effect (if a person thinks he will succeed, he is more likely to succeed). To this purpose, we extend a simple agency model with moral hazard and limited liability by introducing a model of reference-dependent preferences (RDP) by Kőszegi and Rabin (2004). We show that the agent with high expectations about his performance can be induced to choose high effort with low-powered incentives. We then argue that the principal’s expectation has an important role as an equilibrium selection device, when the level of the agent’s ability is intermediate