Incentive Efficiency Losses from Inequity Aversion in Optimal Contract

Abstract

A series of economic experiments have proven that many people are inequity averse and prefer a more fair allocation. Then, how will the inequity aversion influence the incentive efficiency in the optimal contract? On one hand, the inequity averse agent will surely suffer disutility when facing unfair allocation. Hence, the inequity aversion adds an incentive constraint and must reduce incentive efficiency. On the other hand, the inequity averse agent can be rewarded for good performance not only by paying more but also by paying more equitably. Thus, the inequity aversion delivers an incentive instrument and can enhance incentive efficiency. We show in this paper that the former is the dominating one. For the agent with inequity aversion, besides the risk compensation from asymmetric information as revealed in the standard contract theory, the principal has to pay the inequity rent, resulted from any possible unfair allocation, and the risk compensation from inequity aversion, resulted from the distortion of balance between insurance and incentives, both of which are the incentive efficiency losses from the inequity aversion. Consequently, to screen and evaluate the inequity aversion of employees is very important for employers to design suitable incentive systems.