Friends or Foes? Optimal Incentives for Reciprocal Agents

Widely used performance-based contracts put (positive or negative) externalities on co-workers. These externalities have been proven to shape an organization’s working climate especially when workers exhibit social preferences. However, it is a priori unclear whether a more friendly or a more competitive working environment should be encouraged. In this paper I consider a theoretical model in which a self-interested principal has to motivate a set of agents. Agents are symmetric, potentially risk-averse and exhibit reciprocity concerns towards each other. The optimal incentive scheme is derived solving a psychological game with asymmetric information about effort choices. I show that the optimal incentive design depends on the interplay between the agents’ attitudes towards risks and their preferences for reciprocity. In particular, the optimal scheme implements (i) a relative performance compensation scheme which induces an exchange of unkindness if agents are relatively little risk averse and (ii) a joint performance compensation scheme which induces an exchange of kindness if agents are sufficiently risk averse. My findings can explain some puzzling empirical results.