A Note On Envy And Earnings Inequality Under Limited Liability Contracts

Abstract

The paper analyzes an ex-ante contracting with limited liability constraints when agents feel envious of others' higher wages. We show that depending on the degree of limited liability constraints, the principal requires various distortions in output at both the top and bottom productivity levels for agent's type. Compared to the result without envy, the output gap between efficient and inefficient agents is less spread out. Moreover, when the degree of envy is sufficiently large, bunching can always occur. Hence, the first-best solutions for both types of agent are never obtained with envy regardless of the burden of limited liability.