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Contracting in Peer Networks

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Listed:
  • Peter M. DeMarzo
  • Ron Kaniel

Abstract

We consider multi-agent multi-firm contracting when agents benchmark their wages to a weighted average of their peers, where weights may vary within and across firms. Despite common shocks, compensation benchmarking can undo performance benchmarking, so that wages load positively rather than negatively on peer output. Although contracts appear inefficient, when a single principal commits to a public contract, the optimal contract hedges agents’ relative wage risk without sacrificing efficiency. Moreover, the principal can exploit any asymmetries in peer effects to enhance profits. With multiple principals, or a principal that is unable to commit, a “rat race” emerges in which agents are more productive, but wages increase even more, reducing profits and undermining efficiency. Effort levels are too high rather than too low, and can exceed first best. Wage transparency and disclosure requirements exacerbate these effects.

Suggested Citation

  • Peter M. DeMarzo & Ron Kaniel, 2021. "Contracting in Peer Networks," NBER Working Papers 28378, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:28378
    Note: CF
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    JEL classification:

    • D85 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Network Formation
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G3 - Financial Economics - - Corporate Finance and Governance
    • G4 - Financial Economics - - Behavioral Finance
    • J3 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs

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