Abstract
Tournaments, reward structures based on rank order, are compared with individual contracts in a model with one risk-neutral principal and many risk-averse agents. Each agent's output is a stochastic function of his effort level plus an additive shock term that is common to all the agents. The principal observes only the output levels of the agents. It is shown that, in the absence of a common shock, using optimal independent contracts dominates using the optimal tournament. Conversely, if the distribution of the common shock is sufficiently diffuse, using the optimal tournament dominates using optimal independent contracts. Finally, it is shown that for a sufficiently large number of agents, a principal who cannot observe the common shock but uses the optimal tournament does as well as one who can observe the shock and uses independent contracts.
Highlights
At the Olympics prizes are awarded, not on the basis of absolute performance, but on the basis of relative performance
Among other things, that for either additive or multiplicative shocks, because the mean output level is a sufficient statistic for all of the inf"ormation about the common shock, optimal contracts can be designed in which each agent's reward depends only on his own output level and on the mean output level
All agents' output levels are subject to the same random shock
Summary
The Harvard community has made this article openly available. Please share how this access benefits you. Tournaments, reward structures based on rank order, are compared with individual contracts in a model with one riskneutral principal and many risk-averse agents. The principal observes only the output levels of the agents. In the absence of a common shock, using optimal independent contracts dominates using the optimal tournament. If the distribution of the common shock is sufficiendy diffuse, using the optimal tournament dominates using optimal independent contracts. It is shown that for a sufficiently large number of agents, a principal who cannot observe the common shock but uses the optimal tournament does as well as one who can observe the shock and uses independent contracts
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