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

We consider a multi-agent contracting setting when agents have “keeping up with the Joneses†(KUJ) preferences. Because productivity is affected by common shocks, it is optimal to base pay on performance relative to a benchmark. But when agents and care about how their pay compares to others’, relative performance evaluation 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, 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 a “rat race†in which agents are more productive, but wages increase even more, reducing profits. Renegotiation exacerbates this inefficiency when KUJ effects are weak, but can enhance efficiency when KUJ effects are sufficiently strong. Finally, public disclosure of contracts across firms can cause output to collapse.