Contracting in Peer Networks

Peter DeMarzo and Ron Kaniel

No 28378, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: D85 D86 G3 G4 J3 (search for similar items in EconPapers)
Date: 2021-01
New Economics Papers: this item is included in nep-cta, nep-hrm, nep-lma, nep-mic and nep-ure
Note: CF
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Published as PETER M. DEMARZO & RON KANIEL, 2023. "Contracting in Peer Networks," The Journal of Finance, vol 78(5), pages 2725-2778.

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Working Paper: Contracting in Peer Networks (2021)
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