The impact of envy on relational employment contracts

We study the effects of envy on relational employment contracts in a standard moral hazard setup with two agents. Performance is evaluated via an observable, but non-contractible signal which reflects an agent's individual contribution to firm value. Both agents exhibit horizontal disadvantageous inequity aversion. In contrast to the literature, we find that inequity aversion may be beneficial; in the presence of envy, for a certain range of interest rates, relational contracts may be more profitable. For some interest rates reputational equilibria exist only with envious agents.