When to use tournament incentives? Evidence from an investment experiment

Abstract

This paper theoretically and experimentally investigates how different tournament incentives affect managerial decision-making and firm value. Our theoretical model shows that when the economy is in a downturn, linear incentive and elimination contests can ensure that CEO-optimal investment (maximize personal income) is consistent with firm-optimal investment (maximize firm value), while a winner-take-all tournament makes CEO-optimal investment deviate from firm-optimal investment. When the economy is prosperous, a linear incentive and winner-take-all can ensure that CEO-optimal investment is consistent with firm-optimal investment, while elimination contests make CEO-optimal investment deviate from firm-optimal investment. The experimental results broadly support the above predictions. However, elimination contests (winner-take-all) are more efficient than linear incentives when the economy is in a downturn (i.e., prosperous). We conjecture that this result occurs because elimination contests and winner-take-all, which involve interactions between subjects, induce learning effects. In addition, winner-take-all and elimination contests lead to more rational behavior than linear incentives.