Optimal contracts under interpersonal projection

Abstract

We study a moral hazard model where multiple agents exhibit interpersonal projection bias, perceiving their peers' production states as similar to their own. Each agent's production state is private information. We characterize optimal contracts with limited liability that induce effort from agents in a production state better than a given cutoff. When the cutoff is sufficiently low (high), relative (resp. joint) performance evaluation is optimal if individual outcomes are contractible despite the absence of common shocks and informational or technological externalities. By exploiting agents' biases, the principal reduces expected wages. However, if only joint outcomes are contractible, optimal wages may increase with the degree of projection bias.