This paper studies moral hazard in teams using a model where efforts are promoted via the combination of profit shares and relational contracts. The focus is on how these two forms of incentives interact. According to the degree of effort observability and the importance of future interaction, the optimal allocation of profit shares can range from a wide dispersion across players to a full concentration of shares in the hands of a single player. When shares are sufficiently concentrated, the corresponding residual claimant can also adopt the role of administering all relational contracts, therefore serving as an endogenously chosen principal.

The principal motivating factor in our lives is the pursuit of happiness. In most cultures, when seeking this end, individuals place a high priority on income, and spend much of their waking time procuring this intermediate goal. The connection between income and happiness is by no means trivial, however. Two critical factors come into play. First, beyond subsistence level, the positive effect of a permanent change in income tends to be short lived. We rapidly become accustomed to a more expensive lifestyle. A common name for this feature is habit formation. Second, the satisfaction derived from a given level of income is sharply dependent on how it compares to the income of peers. See, for example, Andrew B. Abel (1990), Becker (1996), and William A. Brock and Steven N. Durlauf (2001) for a demonstration of the influence of habits and peer comparisons over behavior, and see Shane Frederick and George Loewenstein (1999) for a review of the underlying psychology. Habits and peer comparisons mean that an individual is not concerned mainly with her absolute level of income, but rather with the difference between her income and a benchmark that changes over time. In recent years, economists have become increasingly interested in this fact. This interest has been both applied (i.e., the study of habits and peer influences over behavior and the analysis of happiness surveys) and theoretical (i.e., a search for biological foundations). But unlike other more developed areas of economics, these two approaches remain fairly separate from each other. In particular, the existing theoretical work is motivated only by the most basic empirical observations. And the existing applied work, for the most part, has not been influenced by theoretical results. In this essay, we seek to reduce the distance between these two literature strands. In particuHabits, Peers, and Happiness: An Evolutionary Perspective

We model happiness as a measurement tool used to rank alternative actions. Evolution favors a happiness function that measures the individual’s success in relative terms. The optimal function is based on a time‐varying reference point—or performance benchmark—that is updated over time in a statistically optimal way in order to match the individual’s potential. Habits and peer comparisons arise as special cases of such an updating process. This updating also results in a volatile level of happiness that continuously reverts to its long‐term mean. Throughout, we draw a parallel with a problem of optimal incentives, which allows us to apply statistical insights from agency theory to the study of happiness.