Optimal Incentive Contracts under Relative Income Concerns

We are studying in this paper an interplay between workers in organizations under the assumption that workers exhibit behavioral biases: envy, jealousy, or admiration towards the other co-workers ’ compensations. We assume workers care about their relative position, and we study the impact of this assumption on their efforts and on their optimal incentive contracts. We explicitly solve for the optimal incentive contract of moral hazard a la Holmstrom Milgrom (1987) when there is team production, each agent’s effort generates an observable signal that depends on efforts of all. One of the important findings is that a worker’s optimal effort is less than it would be in the absence of any behavioral biases in workers’ judgments. That is, envious workers exert less effort. We also show that the value of the firm is less in the presence of envy or jealousy; that is, envious behavior is destructive for organizations. The sensitivity of the workers ’ pay to their own performance is studied. Consistent with Tirole (2001), in the presence of agency problems (induced by envy or jealousy), the optimal compensation exhibits high pay-for-performance sensitivity