Inequity Aversion and Moral Hazard with Multiple Agents

Abstract

We analyze how inequity aversion interacts with incentive provision in an otherwise standard moral hazard model with two risk averse agents. We find that behindness aversion (suffering only when being worse off) among agents unambiguously increases agency costs of providing incentives. This holds true if agents also suffer from being better off unless they account for effort costs in their comparisons. Increased agency costs can undermine efficiency in two ways. First, inequity aversion may render equitable flat wage contracts optimal even though incentive contracts are optimal with selfish agents. Second, to avoid social comparisons the principal may employ one agent only, thereby forgoing the efficient effort provision of the second agent. Furthermore, we discuss implications for the internal organization and the boundary of the firm.