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Optimal incentive contracts under relative income concerns

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Abstract

We are studying in this article an interplay between workers in organizations under the assumption that workers exhibit behavioral biases: envy, jealousy, or admiration toward the other coworkers’ compensation. 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 and Milgrom (Econometrica 55:303–328, 1987). We model team production by agents in which each agent’s effort generates an observable signal and depends on efforts of other agents. One of the important findings is that an agent’s optimal effort is negatively impacted by the behavioral biases in other agents’ judgments. We also show envious behavior is destructive for organizations. Consistent with Tirole (Econometrica 69(1):1–35, 2001), our findings suggest that in the presence of agency problems induced by envy or jealousy, the optimal compensation exhibits high pay-for-performance sensitivity.

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Authors and Affiliations

  1. Business Division of Seaver College, Pepperdine University, Malibu, CA, 90263, USA

    Levon Goukasian

  2. Department of Information Systems, Business Statistics and Operation Management, School of Business and Management, Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong

    Xuhu Wan

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  1. Levon Goukasian
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  2. Xuhu Wan
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Correspondence to Xuhu Wan.

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Goukasian, L., Wan, X. Optimal incentive contracts under relative income concerns. Math Finan Econ 4, 57–86 (2010). https://doi.org/10.1007/s11579-010-0035-9

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