Pay Equality and Envy Among Unequals the Impact of Equal-Fixed-Wage Constraints on Incentive Pay and Unemployment

In many countries wages are set by collective agreements. Such agreements tend to impose wage equality among the a⁄ected workers. We use a moral-hazard environment with two inferiority-averse workers who di⁄er in their productivities but are otherwise identical. In this setting, we analyze the impact of imposing such xed-wage equality and highlight the interaction between these workers characteristics and their e⁄ects on the optimal contracts and employment. We nd that, absent any further restrictions on the incentive contracts, xed-wage equality implies bonus equality. However, once the aversion to inferiority becomes su¢ ciently high, the associated inequality premium induces the employer to lay the lowability worker o⁄, thereby generating unemployment even if productivity di⁄erences are small. Finally, in the more realistic case of limited liability, the presence of social preferences makes unemployment less likely due to the intrinsic incentives arising from the workers social preferences