The Intensity of Incentives in Firms and Markets: Moral Hazard with Envious Agents

While most market transactions are subject to strong incentives,
transactions within firms are often not incentivized. We offer an
explanation for this observation based on envy among agents in an
otherwise standard moral hazard model with multiple agents. Envious
agents suffer if other agents receive a higher wage due to random
shocks to their performance measures. The necessary compensation
for expected envy renders incentive provision more expensive, which
generates a tendency towards flat-wage contracts. Moreover,
empirical evidence suggests that social comparisons like envy are
more pronounced among employees within firms than among individuals
who interact only in the market. Flat-wage contracts are thus more
likely to be optimal in firms than in markets.