Ex ante contracting with inequity aversion

Abstract

We introduce that the principal and the agent can contract at the ex ante stage, and allow for risk-averse agents with inequity aversion to analyse the properties of the optimal incentive scheme under adverse selection. Contrary to the solutions of standard adverse selection problems, our main finding is that the efficient agent who is a risk-averse in presence of concerns with inequity produces more than first-best level, whereas the inefficient agent produces less than second-best level than canonical pure adverse selection output.

Notes

¹ Sappington (2004) focuses on the condition under which all inequity can be avoided at no cost by changing the provision of incentives. Siemens (2004b) analyses optimal employment contracts with risk neutral agent with inequity aversion.

² Despite a possibility of misunderstanding in terminology selection, this study also employs the classification of the textbooks and explains this under the framework of an adverse selection model for the sake of convenience

³ Accordingly, when a principal contracts with the agents, she needs ex ante participation constraints and ex post incentive compatibility conditions depending on the types of agents.

⁴ At an anecdotal level, after entrance of university, students may discover that they are not interested in a major they already have chosen, which is not known by the university authorities. For the view of university, there may be inefficiency to switch students about majors.

⁵ One could extend the model and allow for an inequity averse agent too: agents compare their rent [w_k  − t_ix_k ] to the other agent's rent [w_k  − t_jx_m ]. But in order to keep the exposition as possible we present only this version.

⁶ In order to show , it is sufficient to show that

⁷ Setting α = 0 yields the standard solution in the adverse selection framework, where the agent perfectly has no envy.