Efficiency in Team Production with Inequity Averse Agents

This paper analyzes how incentive provision in team production is affected if agents are inequity averse in the sense of Fehr and Schmidt (1999). By deriving optimal contracts accounting for inequity aversion we find that efficient effort choices can be implemented with simple budget-balancing sharing rules if agents are sufficiently inequity averse. Conditions on inequity aversion become less restrictive the smaller the team. This fits the common observation that small teams often work well whereas larger ones suffer from free-riding. Furthermore we show that if all agents working can be implemented as a Nash equilibrium, it can be implemented as the unique Nash equilibrium if teams contain more than three agents. Our results have implications for the optimal organization and boundary of firms. JEL Classification: C7, D8, D63, L2.