Peer Pressure and Incentives

We analyze the effect of peer pressure on the incentives offered by a principal, supposing that there are two agents who make costly efforts to produce a single output. The agents are rewarded by the principal, contingent on the realized output. In addition to this pecuniary payoff, we consider the psychological payoff brought by peer pressure. That is, each agent feels peer pressure if his effort level deviates from the average level of effort exerted by others. We consider two significant features of peer pressure. First, we consider that the agents are heterogeneous with respect to their productivities. Second, we consider that each agent feels pressure not only when his effort level is below the average level, but also when it is above that level. Then, peer pressure affects the incentives. More precisely, the principal offers high-powered incentives to the low-productivity agent and low-powered incentives to the high-productivity agent. As a result, the principal can alleviate peer pressure by offering incentives based on each agentfs productivity.