This paper incorporates the notion of worker morale into an economic m
odel of pay and performance, and examines its implications for the eff
icacy and design of performance-based pay schemes, A worker's morale i
s determined by his relative pay status. A contract that rewards only
individual performance can therefore undermine the morale of the least
skilled workers in a firm and thereby adversely affect their producti
vity. On the other hand, competition for relative pay status tends to
boost the productivity of highly skilled workers in the firm. The net
effect on productivity depends on the composition of the firm's workfo
rce. If the workforce is sufficiently heterogeneous then the inclusion
of a profit-sharing component in the pay contract, which reduces the
pay differential across workers, can sufficiently boost the morale of
the least skilled workers as to improve overall productivity and profi
tability.