Standard Wages, Incentive Contracts, and Employment: The Role of Envy Among Unequals

Abstract

In many countries, wages are set by collective agreements, which tend to impose standard wages across workers in the same sector and job. We analyze the impact of imposing such standard wages on labor market outcomes. We set the labor relationship in a moral-hazard environment where two inferiority-averse workers who differ only in their productive abilities may be hired by an employer. The latter offers the workers incentive contracts with identical fixed wages and potentially individualized bonuses. In this environment, we highlight the interaction between worker characteristics, optimal incentive contracts, and employment. We find that, absent any further restrictions on the incentive contracts, fixed-wage equality implies bonus equality. However, once the workers' aversion to inferiority becomes sufficiently high, the optimal contract deters the low-ability worker from accepting it, thereby generating unemployment even if productivity differences between the workers are small. Finally, in the more realistic case of limited liability, bonus pay is tailored to the workers' productivities as long as rents are paid. In that case, the presence of social preferences makes unemployment less likely due to the intrinsic incentives arising from the workers' social preferences.