Relational Contracts and Social Comparison Costs in Organizations

Abstract: Organizations consist of agents with different skills or bargaining power, and may need to offer them contract terms that take such differences into account. Yet, differential contract terms may trigger social comparisons among agents, imposing a cost on the organization. First, agents with more unfavorable contract terms than their peers may feel frustrated, forcing the organization to compress their compensation upwards in order to retain them. Second, those agents may retaliate against the organization by shirking or boycotting production. In this paper, we develop a simple model to analyze how organizations optimally combine formal and informal contracts to minimize these “social comparison costs”. Our key assumption is that social comparison is more acute when differential contract terms are formalized, and hence more broadly known throughout the organization, than when they are kept informal. We show that as the organization becomes more relational—for instance, because its parties’ time horizon expands—observable (formal) contract terms should become more homogeneous and observable (formal) compensation levels should decrease. We discuss applications to the employment relationship as well as to inter-firm organizations such as distribution networks and supply chains.