Income Inequality and Incentives in Economies with Other-regarding Preferences
Abstract: We analyze model economies populated by individuals who care about their own income and wealth but also regard their position relative to the economy's average values of these variables. Furthermore, these individuals differ in their initial wealth. We consider inequality averse and competitive populations. Poor individuals are inferiority averse in both cases while rich individuals are superiority averse in the former but superiority seeking in the latter case. We investigate the impact of such preferences and wealth inequality on incentive contracts, output, and welfare. Unlike former agency models with inequality aversion within firms, we find that increasing inferiority aversion at the societal level tends to raise equilibrium effort and reduce wage costs. The same holds also for superiority seeking workers. By contrast, raising superiority aversion lowers effort and increases wage costs. A parameterized version of the model which roughly mimics some key features of the industrialized world shows that, even under inequality aversion, increased initial wealth differences lead to higher average output, entail distributional utility losses, and result in a more uneven income distribution.