Optimal Incentives With Other‐Regarding Principal and Agents

ABSTRACT Analyzing interactions between an other‐regarding principal and two other‐regarding agents, we show with continuous efforts and outcomes that “team contracts” are optimal if the principal is inequity averse or not “too status seeking.” However, if the principal is sufficiently status seeking and the agents' wages are far apart, relative performance contracts or independent contracts could be the optimal choice of the principal. However, a status‐seeking principal will certainly offer relative performance contracts to self‐regarding agents. The above results hold when the ‘direct wage incentive’ effect is not too high. With discrete efforts and outcomes, both team contracts and relative performance contracts can be optimal if the principal is “status seeking” or “not too inequity averse.” But an extreme independent contract can also be optimal when the principal is sufficiently inequity averse. Similar results hold when the projects of the agents are correlated. With a “fair” principal, ceteris paribus, team contracts are more likely over relative performance contracts, however, relative performance contracts can also be optimal with other‐regarding agents.