Abstract

We study how the optimal contract in team production is a¤ected when employees are averse to inequity in the sense described by Fehr and Schmidt (1999). By designing a reward scheme that creates inequity o¤ the desired equilibrium, the employer can induce employees to perform e¤ort at a lower total wage cost than when they are not inequity averse. We also show that the optimal output choice might change when employees are inequity averse. Finally, we show that an employer can gain, and never lose, by designing a contract that accounts for inequity aversion, even if employees have standard preferences.