Big fish in a bigger pond: positional envy in the workplace

In an agency model with hidden information, we examine how skill heterogeneity can affect the design of optimal contracts and the distribution of rents across workers. We first consider a standard model with two worker types, and show that under certain conditions, the information rent accruing to high-ability workers can be non-monotonic, first increasing and then decreasing in the ability gap. We then introduce other-regarding preferences, and assume that workers can incur a utility loss from envy, due to unfavourable contract rent comparisons. We show that in this extended framework, where high-ability workers also obtain an envy rent from their contracts, the ability gap that maximizes their payoff is decreasing in the intensity of envy, meaning that they tend to prefer less skill heterogeneity in the workplace. Finally, we show that from the principal’s perspective, separating contracts dominate both pooling and screening contracts where low-ability workers are driven out of the market. This result applies to the standard hidden-information problem, and also extends to the framework with other-regarding preferences, even though envy raises the cost of separation.