Incentive Contracts and Peer Effects in the Workplace

Abstract

We analyze how firms should design wage contracts when workers collaborate in teams and effort costs depend on colleagues through a peer network. Performance-based compensation generates incentives that cascade through the organization, which firms target to boost profits. We analyze optimal incentive design if firms can -- and can't -- fully discriminate across workers, and when the production technology is separable or complementary across divisions. When workers' effort is substitutable, the most central workers -- those who influence most colleagues directly and indirectly -- receive the steepest incentives only when output risk is sufficiently large; otherwise firms prioritize workers who are closer to those they influence. When production technology exhibits complementarity across teams, stronger incentives are assigned to workers who influence colleagues in small teams that receive little influence from others. We derive a sufficient network statistic that measures the profit loss when firms must compensate workers of varying centrality equally. Finally, we apply our findings to organizational design questions, such as optimal firm structure and workforce investments.