Social Preferences, Sorting, and Employment Contracts∗

This paper studies equilibrium employment contracts if workers have private information on their skills and their propensity for inequity aversion. Inequity averse workers suffer if other workers in their reference group get different rents defined as income net of production costs. Social preferences are shown to cause no sorting effects unless contract choices influence what workers consider to be their reference group. In this case inequity aversion induces a monopsonist to either distort production quantities or to exclude workers with low skills. Further, competition can promote the emergence of efficient sorting opportunities, thereby rendering inequity aversion irrelevant. But depending on the definition of reference groups, competition can also aggravate distortions