The costs and benefits of tournament in a frictional labor market

Abstract

This study provides a search and match model with endogenous firm growth, wherein firms post tournament contracts. We show that workers tend to shirk their efforts as firms grow if the right tails of idiosyncratic productivity shocks decay fast enough. Therefore, a dynamic innovation process of the compensation scheme is required to persistently provide incentives. Tournament induces wage dispersion both within and between firms. The quantitative analysis indicates that tournament induces better performances than the quota contract, especially with thin-tailed shock distributions. Nevertheless, with heavy-tailed shock distributions, single-prize schemes induce the involution problem, which reduces the performance improvement of enforcing tournament in large firms. This inefficiency is mitigated by offering prizes to multiple workers.