Abstract
This paper studies a monopsonistic firm's optimal employment contracts if workers have private information on both their propensity for social comparisons and their ability. Employees of the firm are taken to form their own distinct reference group. It is shown that screening workers with equal ability according to their social preferences is then not possible within the firm. In consequence, the firm distorts production by its employees with low ability, or it excludes workers with low ability and a high propensity for social comparisons. This highlights that firms can use both contractual and organizational measures to reduce the costs arising from workers' social preferences. Further, information on workers' social preferences reduces the latter's impact on employment contracts without changing it qualitatively.
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