Inequity Aversion , Adverse Selection and Employment Contracts ∗

This paper analyzes the interaction of fairness concerns and social comparisons with asymmetric information and incentives within the context of a firm’s employment decision. It studies optimal, incentive-compatible employment contracts if each worker is inequity averse he suffers from being ‘worse off’ than his colleagues and has private information about his productivity. Inequity aversion is modelled in the spirit of Fehr and Schmidt (1999). Optimal contracts depend delicately on what workers compare. If workers compare income only, inequity aversion causes an income compression and possibly unemployment of low-skilled workers. Yet contrary to the common notion in labor economics, if workers also account for production costs in their comparisons, inequity aversion increases the income difference between workers with different productivity, and all types of workers are always employed.