Incentives and Relative-Wealth Concerns: Theory and Evidence

Abstract

In this work I show that if risk-averse agents prefer both to be richer in absolute terms and to be richer than their peers (relative-wealth concerns), then 1) they will prefer positive correlation between their payoffs and the payoffs of other agents, and 2) they will be averse to negative correlation between payoffs. I test these theoretical predictions in a laboratory experiment. I find that subjects prefer positively correlated payoffs over risk-free and negatively correlated payoffs. Furthermore, subjects who by observing other participants' payoffs signal stronger relative-wealth concerns, also show stronger aversion to negatively correlated payoffs. Women appear to be concerned about other agents' payoffs more than men. This novel evidence has implications that help explain why firms apparently use profit-sharing and broad-based incentives contracts too extensively, and why Relative Performance Evaluation (RPE) contracts are scarcely used in common compensation practice. Further, I show that in the presence of relative-wealth concerns 1) it is optimal for a principal to offer a compensation schedule linked to the overall firm or team performance, even when each agent's performance is observable, contractible and independent on the actions taken by his/her colleagues, 2) Relative Performance Evaluation is less desirable for the principal. Finally I investigate under what conditions it is optimal for a self-concerned principal to enforce a wage secrecy policy within an organization.