Incentives, Compensation, and Social Welfare

Alternative reward structures under conditions of moral hazard are analyzed from a social welfare standpoint. We argue that social welfare judgements under uncertainty should incorporate ex post judgements; in particular, a distribution-sensitive planner should have a preference for positive affiliation of individual ex post utilities. A genuine conflict between distributional preferences and the need to provide effort incentives then arises. The welfare implications of tournaments and individualistic contracts are compared in a context of independent production uncertainties. Welfare optimal reward structures are analyzed in a fairly general setting, and compared to optimal compensation schemes in a capitalist firm. The analysis throws light on the welfare properties of competition and the sense in which it is overrepresented in a capitalist firm.