Wage Bargaining when Workers Have Fairness Concerns

We analyze optimal labor contracts when workers are inequity averse towards the employer. Welfare is maximized for an equal sharing rule of surplus between the worker and the firm. That is, profit sharing is optimal even if effort is contractible. If the firm can make a take-it-or leave-it offer, the optimal contract is also dependent on output but always suboptimal with respect to welfare. When the parties bargain over the contract, the optimal division of surplus is more equitable compared to the purely self-regarding case. Moreover, the agreement approaches the welfare-optimal contract as the parties' bargaining power converges. Our findings imply that raising the bargaining power of the less powerful party may increase welfare