Inequity Version and Team Incentives

We study optimal contracts in a simple model where employees are averse to inequity as modelled by Fehr and Schmidt (1999). A "selfish" employer can profitably exploit such preferences among its employees by offering contracts which create inequity off-equilibrium and thus, they would leave employees feeling envy or guilt when they do not meet the employer's demands. Such contracts resemble team and relative performance contracts, and thus we derive conditions under which it may be beneficial to form work teams of employees with distributional concerns who were previously working individually. Similar results are obtained for status-seeking and efficiency concerns preferences.