Academic journal article Economic Inquiry

Piece-Rate Contracts for Other-Regarding Workers

Academic journal article Economic Inquiry

Piece-Rate Contracts for Other-Regarding Workers

Article excerpt

I. INTRODUCTION

A wide array of experimental evidence suggests that individuals care not only about their own outcomes but the outcomes of their opponents as well; that is, individuals do not necessarily have "selfish" preferences and rather exhibit "other-regarding" or "social" preferences (see Camerer 2003, for a summary). Given the pervasive nature of other-regarding preferences, accounting for them in real-world decision-making problems is important because other-regarding behaviors such as fairness, trust, and inequality aversion may significantly affect policy and contracting decisions. This paper concentrates on one prevalent type of other-regarding preferences, behavior toward inequality, and applies it to a principal-agent contracting model. Using piece-rate contracts, (1) we focus on two important questions. (2) First, how do attitudes toward inequality affect how workers respond to incentives? Second, how do attitudes toward inequality affect the incentives offered by the firm?

Analyzing the impact of attitudes toward inequality on contracting issues is reasonable because when workers are paid according to their performance, pay inequality arises naturally. Frank (1985) argues that humans are hardwired with a preference for higher status and therefore like any change that moves them up relative to their coworkers. On the other hand, experimental evidence on ultimatum games, dictator games, and the like has led researchers to assume that subjects dislike inequality (e.g., Bolton and Ockenfels 2000; Fehr and Schmidt 1999) and therefore dislike any change that makes payoffs less equal. Either way, pay inequality matters to workers, and it is important to derive the correct incentive system in the presence of these preferences.

Our paper has two major results that can best be summarized when workers have identical preferences and effort costs. First, other-regarding workers exert more effort than self-oriented ones when they are either competitive (i.e., have a preference for status) or behindness averse. This result establishes that piece rates can motivate other-regarding workers more than they motivate purely self-interested ones, and so firms can get a bigger bang for their buck when they use incentive pay with the right types of other-regarding workers. Second, if workers are identical and either inequality averse or behindness averse, the firm's profit-maximizing piece rate is lower than it would be if workers were purely self-interested. In other words, inequality and behindness aversion both lead to wage compression.

To capture the different inequality attitudes, we employ the Fehr and Schmidt (1999) model of other-regarding preferences. There are several reasons for using their model: it can fit data from a variety of experimental settings (as shown in their original paper), it has an axiomatic foundation (Neilson 2006), and it has been used successfully in other applications of other-regarding preferences (e.g., Itoh 2004). In the FehrSchmidt model, an individual receives (self-oriented) utility from his own payoff but (social) disutility from any difference between his partner/opponent's payoff and his own. In a principal-agent setting, the agents' payoffs are determined by both the pay they receive from the principal and the effort costs they bear. We modify the original Fehr-Schmidt model in two ways: first to allow for other behavioral patterns besides inequality aversion and second to make social disutility depend on pay differences, while self-oriented utility depends on pay minus effort costs.

Although there are several good reasons for assuming that workers compare pay but not effort costs, the current literature suggests that what workers compare is likely context dependent. In his book addressing wage rigidity as support for internal pay equity, Bewley (1999) states that employees care about their pay relative to that of their coworkers; he also finds that even when pay secrecy is a company policy, workers often reveal how much they make to others. …

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