Incentives, Compensation, and Social Welfare

Abstract

Alternative wage structures under conditions of moral hazard are analysed from a social welfare standpoint. It is argued that ex post equity judgements in an uncertainty context should incorporate a preference for “positive correlation” of utilities of different individuals. In the design of compensation schemes, this may give rise to a conflict between ex post equity objectives and the need to provide effort incentives: relative performance clauses in compensation schemes that are useful for providing incentives are undesirable from an ex post equity standpoint. This is demonstrated by showing (a) in a context of independent production uncertainties, every rankorder tournament is welfare-dominated by a set of independent (randomized) contracts, and (b) welfare-optimal compensation schemes in general depend separately on an equity and an incentive component that tend to correlate agent compensations in different directions.