Collective wages and incentive contracts: On the role of envy and worker diversity

In many countries, collective agreements tend to equalize wages across workers in the same sector and job. We analyze the impact of imposing wage equality on incentive contracts and firms’ hiring policies. In our setting, an employer considers hiring two envious workers who differ only in their productivities. The employer offers the workers incentive contracts with identical fixed wages and potentially individualized bonuses. In this environment, we highlight the interaction between worker characteristics, optimal incentive contracts, and the employer's hiring policy. We find that, when the collective wage does not constrain the employer, fixed-wage equality implies bonus equality. Moreover, once the workers’ sensitivity to disadvantageous inequality becomes sufficiently high, the optimal contract deters the low-productivity worker from accepting it, even if productivity differences between the workers are small. Finally, where the agreed-upon fixed wage binds the employer, bonus pay is tailored to the workers’ productivity. In that case, the presence of social preferences allows the employer to exploit the intrinsic incentives arising from the workers’ relative-income concerns. Furthermore, in this scenario, it is more likely that both workers will be hired.