Optimal Contracts for Ambitious Team Workers
30 Pages Posted: 23 Nov 2005
Date Written: November 13, 2005
This paper invesigates the optimal compensation scheme for workers in a team who value not only absolute but also relative incomes. A worker is said to be more ambitious if his utility places more weight on relative income. In this case the firm can exploit the worker's preference for relative comparison to design a compensation scheme that induces the same effort level with lower cost. Under the optimal compensation scheme, the workers' wages are shown to depend on relative performance, and exhibit wage compression. More importantly, even if the production technology calls for absolute performance evaluation in the traditional principal-agent framework, the optimal wage structure still relies on relative performance. Finally, in contrast to past literature, worker heterogeneity is shown to reduce the firm's profit.
Keywords: relative performance, absolute performance, promotion tournament, wage contract, relative income comparison
JEL Classification: D2, D8, J3, L2
Suggested Citation: Suggested Citation