Relative Pay for Non-Relative Performance: Keeping Up with the Joneses with Optimal Contracts

51 Pages Posted: 29 Mar 2016 Last revised: 7 Apr 2017

See all articles by Peter M. DeMarzo

Peter M. DeMarzo

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Ron Kaniel

University of Rochester - Simon Business School; CEPR

Multiple version iconThere are 2 versions of this paper

Date Written: April 1, 2017

Abstract

We consider a multi-agent contracting setting when agents have “keeping up with the Joneses” (KUJ) preferences. Because productivity is affected by common shocks, it is optimal to base pay on performance relative to a benchmark. But when agents and care about how their pay compares to others’, relative performance evaluation increases agents’ perceived risk. We show that when a single principal (or social planner) can commit to a public contract, the optimal contract hedges the risk of the agent’s relative wage without sacrificing efficiency. While output is unchanged, hedging makes the contracts appear inefficient in the sense that performance is inadequately benchmarked. We also show that when there are multiple principals, or the principal is unable to commit, efficiency is undermined. In particular, KUJ effects induce a “rat race” in which agents are more productive, but wages increase even more, reducing profits. Renegotiation exacerbates this inefficiency when KUJ effects are weak, but can enhance efficiency when KUJ effects are sufficiently strong. Finally, public disclosure of contracts across firms can cause output to collapse.

Keywords: contracting, externality, keeping up with Joneses, relative performance, moral hazard, peers

Suggested Citation

DeMarzo, Peter M. and Kaniel, Ron, Relative Pay for Non-Relative Performance: Keeping Up with the Joneses with Optimal Contracts (April 1, 2017). Available at SSRN: https://ssrn.com/abstract=2755856 or http://dx.doi.org/10.2139/ssrn.2755856

Peter M. DeMarzo

Stanford Graduate School of Business ( email )

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National Bureau of Economic Research (NBER)

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Ron Kaniel (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

HOME PAGE: http://rkaniel.simon.rochester.edu

CEPR ( email )

London
United Kingdom

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