Inequity aversion in multi-task agency problems

Abstract

This paper studies how inequity aversion affects the optimal incentive contract in a multi-task principal–agent model with a non-congruent performance measure. We assume that the agent is inequity averse relative to the principal. The agent is envious if he/she expects to get less than the principal and feels guilty, if he/she expects to be paid more. The agent performs two equally productive tasks, but the contractible performance measure is more sensitive to one task than the other, generating a congruity problem. We find that it is never optimal to offer a contract, which leaves the agent envious. Rather, in equilibrium the principal offers either an equal-pay contract or a contract that leaves the agent feeling guilty. For a lower range of the agent’s reservation utility, the only feasible contract is an equal-pay contract. It requires a distortion of incentives and thus results in agency costs from avoiding inequity in addition to agency costs from incongruity. It follows that the principal would prefer to hire a purely self-interested agent as opposed to an inequity averse one. For an upper range of reservation utilities, a contract that leaves the agent feeling guilty is feasible and preferred to an equal-pay contract. This contract results in costs from inequity, but also reduces costs from incongruity. If the first effect dominates the second, hiring an inequity averse agent again turns out to be detrimental. However, we identify scenarios in which the second effect dominates and hiring an inequity averse agent benefits the principal. Acknowledging that an agent might derive extra utility from being paid more than the principal, rather than to feel guilty, we extend our analysis to capture a status-seeking agent. We find that an agent with such preferences requires less pay but his/her effort choice amplifies the congruity problem. Depending on which of the two effects dominates, the principal either prefers to hire a self-interested or a status-seeking agent.