Relative Pay for Non-Relative Performance: Keeping up with the Joneses with Optimal Contracts

We consider a multi-agent contracting setting when agents derive utility based in part on their pay relative to their peers. Because agents' productivity is affected by common as well as idiosyncratic shocks, it is optimal to base pay on the agent's performance relative to a benchmark of his peers. But when agents have "keeping up with the Joneses" (KUJ) preferences and care about how their pay compares to that of others, relative performance evaluation also increases agents' perceived risk. We show that when a single principal (or social planner) can commit to a public contract, the optimal contract hedges the risk of the agent's relative wage without sacrificing efficiency. While output is unchanged, however, hedging makes the contracts appear inefficient in the sense that performance is inadequately benchmarked. We also show that when there are multiple principals, or the principal is unable to commit, efficiency is undermined. In particular, KUJ effects induce agents to be more productive, but average wages increase even more, reducing firm profits. We also show that if the principal cannot commit not to privately renegotiate contracts, then wages and effort are increased when KUJ effects are weak, but are reduced, enhancing efficiency, when KUJ effects are sufficiently strong. Finally, public disclosure of contracts across firms can cause output to collapse.