The Pond Dilemma with Heterogeneous Relative Concerns

TL;DR

This paper models team formation considering skill differences and relative earnings concerns, revealing how heterogeneity influences matching, wage inequality, outsourcing, and the effects of skill-biased technological change.

Contribution

It introduces a two-dimensional assignment model with imperfect utility transfer, analyzing how heterogeneous preferences affect matching and economic outcomes.

Findings

Heterogeneity in preferences influences optimal skill matching.

Supermodular production benefits all workers and reduces wage inequality.

SBTC incentivizes outsourcing to mitigate social comparison issues.

Abstract

This paper explores team formation when workers differ in skills and their desire to out-earn co-workers. I cast this question as a two-dimensional assignment problem with imperfectly transferable utility and show that equilibrium sorting optimally trades off output maximisation with the need to match high-skill workers to co-workers with weak relative concerns. This can lead to positive (negative) assortative matching in skill even with submodular (supermodular) production functions. Under supermodular production, this heterogeneity in preferences benefits all workers and reduces wage inequality. With submodular production, the distributional consequences are ambiguous, and some workers become worse off. The model reveals that skill-biased technological change (SBTC) incentivises domestic outsourcing, as firms seek to avoid detrimental social comparisons between high- and low-skill workers, thus providing a compelling explanation for the long-term increase in outsourcing. Finally, the benefits of SBTC can trickle down to low-skill workers-but only those whose relative concerns are weak.