Inequity aversion and team incentives

We study optimal contracts in a simple model where employees are averse to inequity, as modeled by Fehr and Schmidt (1999). A "selfish" employer can profitably exploit envy or guilt by offering contracts which create inequity off-equilibrium, i.e., when employees do not meet his demands. Such contracts resemble team and relative performance contracts. We derive conditions for inequity aversion to be in itself a reason to form work teams of distributionally concerned employees, even in situations in which effort is contractible.