Abstract
In our paper, we analyze the interplay of contestant heterogeneity and idiosyncratic risk in rank-order tournaments: While in symmetric tournaments an increase in idiosyncratic risk reduces incentives, in asymmetric tournaments this is not necessarily the case: Rather, we show that increasing the level of idiosyncratic risk in asymmetric tournaments will at first increase and—only after a critical risk level has been reached—reduce incentives. We find this critical risk level to be higher, the larger the degree of contestant heterogeneity. Concerning practical implications, it is more important to reduce idiosyncratic risk in the tournament when contestants are similar and less beneficial when contestants are heterogeneous. In light of the fact that equilibrium effort levels in tournaments with a low level of contestant heterogeneity are by far higher than those in tournaments with high levels of contestant heterogeneity, the advice would be to simultaneously reduce contestant heterogeneity (e.g., by league-building or handicapping) and idiosyncratic risk.
Highlights
Tournament incentives have developed into an important component of organizational reward systems: Employees compete against one another with the best performing employee(s) receiving a predefined tournament prize
We analyze the interplay of contestant heterogeneity and idiosyncratic risk in rank-order tournaments: While in symmetric tournaments an increase in idiosyncratic risk reduces incentives, in asymmetric tournaments this is not necessarily the case: Rather, we show that increasing the level of idiosyncratic risk in asymmetric tournaments will at first increase and—only after a critical risk level has been reached—reduce incentives
While [4] as well as [5] find that in a situation with a low degree of contestant heterogeneity, an increase in idiosyncratic risk will generally reduce tournament incentives, in our framework this is no longer the case: An exogenous increase in the amount of idiosyncratic risk in an asymmetric tournament starting from an initially very low level of risk will rather at first increase tournament incentives and only later on reduce these. The intuition of this ambivalent effect is as follows: At very low levels of risk inherent in the production technology, even a small degree of contestant heterogeneity is apt to distort tournament incentives as the outcome of the tournament becomes more or less predictable: The more able contestant will know that even a low level of effort will make her win the tournament, and the best response of the less able contestant will be to choose a low level of effort as well
Summary
Tournament incentives have developed into an important component of organizational reward systems: Employees compete against one another with the best performing employee(s) receiving a predefined tournament prize (e.g. a promotion, a bonus payment, a travel incentive or the like). While [4] as well as [5] find that in a situation with a low degree of contestant heterogeneity, an (endogenous) increase in idiosyncratic risk will generally reduce tournament incentives, in our framework this is no longer the case: An exogenous increase in the amount of idiosyncratic risk in an asymmetric tournament starting from an initially very low level of risk will rather at first increase tournament incentives and only later on (after a critical level of idiosyncratic risk has been reached) reduce these The intuition of this ambivalent effect is as follows: At very low levels of risk inherent in the production technology, even a small degree of (publicly known) contestant heterogeneity is apt to distort tournament incentives as the outcome of the tournament becomes more or less predictable: The more able contestant will know that even a low level of effort will make her win the tournament, and the best response of the less able contestant will be to choose a low level of effort as well.
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