Inequity Aversion and Optimal Compensation Contracts
Asian Tax Journal Vol. 11 No. 1 (2010), pp. 211-235
Abstract
Unlike the conventional agency model, we assume inequity－averse agents from wages difference, in additional to risk and effort averseness. In this setting, the information not useful in the Holmstrom's (1979) sense, to performance evaluation can be included in the optimal compensation contracts, which helps explain some gaps between the predictions of the standard agency theory and reality. First, one agent's performance is a component in the optimal contract of another agent, which in the standard model is the exceptional case with externalities between agents' works or common uncertainties in the agents' environments. Second, relative performance evaluation may not be an optimal contract even when there are common uncertainties exposed to each agent, which contrasts with the standard agency theory. This explains rare empirical evidences for relative performance evaluation. Third, under agent's inequity averseness toward principal, firm－wide profit or allocated cost, though not useful to performance evaluation, can be included in the optimal contracts, which is the not unusual case in reality, but inconsistent with the existing theory.
Keywords
- agency theory
- inequity averseness
- optimal compensation contracts
- incentives
- perfor- mance evaluation
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