Incentives and Discrimination 1

Optimal incentive mechanisms may require that agents be rewarded differentially even when they are completely identical and induced to act the same. We demonstrate this point using a simple incentive model where agents’ decisions about effort exertion are mapped into a probability that the project will succeed. We show that full discrimination across all agents is required if and only if the technology has increasing returns to scale, and discuss the role of hierarchies in generating optimal incentives. (JEL C72, D23, D78, J31, M52)