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Rank-Order Tournaments as Optimum Labor Contracts Author(s): Edward P.

Lazear and Sherwin Rosen Source: Journal of Political Economy, Vol. 89, No. 5 (Oct., 1981), pp. 841-864 Published by: The University of Chicago Press Stable URL: http://www.jstor.org/stable/1830810 . Accessed: 16/09/2013 11:04
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Rank-Order Tournamentsas Optimum Labor Contracts

EdwardP. Lazear and SherwinRosen
Research University of Chicagoand NationalBureau of Economic

This paper analyzes compensation schemes which pay according to an individual's ordinal rank in an organization ratherthan his output level. When workersare riskneutral,itis shown thatwages based allocation of resources as an upon rank induce the same efficient incentivereward scheme based on individual output levels. Under some circumstances, risk-averseworkersactually prefer to be paid on the basis of rank. In addition, if workersare heterogeneous in ability, low-quality workers attempt to contaminate high-quality firms, resultingin adverse selection. However, if abilityis known in advance, a competitive handicapping structure existswhichallows all in the same organization. workersto compete efficiently

I.

Introduction

It is a familiar proposition that under competitive conditions workers are paid the value of their marginal products. In this paper we show that competitive lotteries are often efficient and sometimes superior to more familiar compensation schemes. For example, the large salaries of executives may provide incentives for all individuals in the firm who, with hard labor, may win one of the coveted top positions. This paper addresses the relation between compensation and incentives in the presence of costly monitoring of workers' efforts and We are indebted to Jerry Green,MertonMiller, JamesMirrlees, GeorgeStigler, and EarlThompson Joseph Stiglitz, for helpful comments. The research wassupported
in part by the National Science Foundation. The research reported here is part of the NBER's research program in Labor Studies. Any opinions expressed are those of the authors and not those of the National Bureau of Economic Research. ?
Journalof PoliticalEconomy, 1981, vol. 89, no. 5] 1981 by The University of Chicago. 0022-3808/81/8905-0006$01.50

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This content downloaded from 128.91.116.8 on Mon, 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions

. Howso that workers can alter their ever.the workeris allowed to control the mean of the distributionby investingin costly skills This content downloaded from 128. In general. Section IV considers issues of when workersare heterogeneous.842 JOURNAL OF POLITICAL ECONOMY output. because prizes are fixed in advance. We consider a rank-order payment scheme which has not been analyzed but which seems to be prevalent in many labor contracts. salaries are not contingent upon the output level of a particular game. inputbased pay is preferablebecause it changes the riskborne by workers in a favorableway.we confineattentionto a single period in all thatfollows. Paying workers on based pay may outweigh the risk-sharing the basis of rank order alters costs of measurement as well as the nature of the risk borne by workers.116. Central to this discussion are the conditions under which mecha(Alchian and Demsetz 1972). But when monitoring costs are so high that moral fromusing outputhazard is a serious problem. then the If inexpensive and reliable monitorsof effort best compensation scheme is a periodic wage based on input. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . gear payment to output. which have been extensivelyanalyzed (see. In the development below we start with the simplestcase of risk the basic issues.The situation often can be improved if compensation is related to a more easily measured output level. sortingand self-selection II. Simple piece rates.This scheme pays prizes to the winnersand losers of labor market contests.91. the reader should thinkof the incentiveproblem in terms of career development and lifetime productivityof workers.It is for these reasons that it is incentivestrucsometimesa superior way to bring about an efficient ture. A wide varietyof incentive payment schemes are used in practice.8 on Mon.the gain in efficiency losses. Stiglitz1975.We argue that in many circumstancesit is optimal to set up executivecompensation along these lines and thatcertainpuzzling features of that market are easily explained in these terms. Performanceincentivesare set by attemptsto win the contest. Cheung 1969. input-wage schemes invite shirking. input with less than perfect detection. e. Piece Rates and Tournaments with Risk Neutrality To keep thingssimpleand to avoid sequential and dynamicaspects of the problem. The worker's(lifetime)output is a random variable whose distribution is controlledby the workerhimself. when monitoringis difficult.In particular.g. nismsexist for monitoringproductivity are available. Mirrlees 1976). Therefore. Then the more general case of to illustrate neutrality risk aversion is treated in Section III." That is.The main differencebetween prizes and other incentiveschemesis thatin a contestearningsdepend on the rank order of contestants and not on "distance.

however.Also. Average skill.a measure of skill or average output.RANK-ORDER TOURNAMENTS 843 prior to enteringthe market.we adopt the simplesttechnologyfor firms. However.For example. withC'.Production requires only labor and is additively separable across workers.whichis more realistic to exposit. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . C" > 0. .This does not affect the risk-neutral solution but does have an effectif workers are risk averse.The crucial assumption is thatproductivity riskis nondiversifiable by the workerhimself. so that owners of firmscan diversify risk either by pooling workers together in one firm or by holding a portfolio. To concentrate on incentive aspects of various contractual arrangements.thatE is i. The random variable E. across individuals.thoughworkersknowtheirinputas well as output.whichis revealed veryslowlyover the worker'slifetime.chosen by the workerwhen youngand priorto a realizationof the random or luck component. Worker j produces lifetimeoutput qj according to qj =/ tj + Ej. Again.8 on Mon. That is another reason forchoosing a long period forthe analysis.1 Here E is lifetime luck such as life-persistent person-effects or an abilityfactor. Employers may observe output but cannot ascertain the extentto whichit is due to investment expenditure or to good fortune or to both. The analysis also applies when there are complemenbut more tarities among workersin production.as appears true of managerial talent. Evidentlya persistentperson or abilityeffect cannot be so diversified when it is undiscoverablequickly. difficult Piece Rates The piece rate is verysimple to analyze when workersare riskneutral.116. It involves paying the worker the value of his product. is produced at cost C(.i.d. By virtue of the independence assumptions. virtually all the resultsof this paper hold true if the error structureis multiplicative rather than additive. (1) where pj is the level of investment. if the period were very short and the random factorwas independentlydistributedacross periods. Let r be the 1 In thispaper the workerhas no choice over o-. managers act as expected value maximizersor as if they were risk neutral. these assumptionsare adopted to illustratebasic issues in the simplestway.j. since they tend to favor overlycautious strategies. is drawn out of a knowndistribution withzero mean and varianceC2. It is assumed. Ej.91. a given productivity realization also depends on a random factor which is beyond anyone's control.for example. This content downloaded from 128. Free entryand a competitive output marketset the value of the product at V per unit. the workercould diversify per period risk by repetitionand a savings account to balance off good and bad years.).

piece rate." The We seek to determinethe competitive prize structure (W1. Tournaments Rank-Order We shall consider two-playertournamentsin which the rules of the game specify a fixedprize W1to the winnerand a fixedprize W2to the loser. Risk-neutralworkerschoose u to maximize expected net return E[rq - C(g)] = r. W1 . decreasing the spread because investmentcosts fall by more than This content downloaded from 128. Ignoringdiscounting.W2. equals its social return. Consequently V = C'(p. All essential aspects of the problem readily generalize to any number of contestants. method proceeds in two steps.C(pu).8 on Mon. Each person plays against the "field. But as contestantsinvest more. subject to a zero-profit It will be seen that a worker's incentivesto invest increase with the spread between winningand losing prizes. The contestis rank order because the margin of winningdoes not affect earnings. because its output and revenue are increased. The necessaryconditionis r = C'(tk) or the familiarrequirementthat investment equates marginalcost and return.844 JOURNAL OF POLITICAL ECONOMY the worker'snet income is rq . and the winner of the contestis determinedby the largestdrawing of q.yieldingthe The marginalcost of investment standard result that piece rates are efficient.91. The firmwould always like to increase the spread. - C(u). 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . First.On the other hand.A worker's production follows (1). so free entryand competitionfor workersimplyr = V. to induce greater investment and higher productivity.W2) that maximizes a constraintby firms. ceteris paribus. Given arbitrarily these strategies. but do not communicate witheach otheror collude.we then find the pair (W1. their costs also rise.the prizes W1 and W2 are fixed and workers' investmentstrategies are analyzed.W2). worker'sexpected utility. That is what limitsthe too large a spread induce excesspread in equilibrium:Firmsoffering A competing firmcan attractall of these workersby sive investment. Contestants precommit their investmentsearly in life.because investment is precommittedand a given player does not know who his opponent will be at the time all decisions are made.). Each wants to improve the probabilityof winning because the return to winning varies with the spread.116. Notice thateven though thereare two and not oligopolisplayersin a given matchthe marketis competitive tic. knowingthe prizes and the rules of the game. the expected profitof a firmis E(Vq - rq) = (V -r).

d. More precisely.k.91.C"()<Oi =j. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .2 2 However. This content downloaded from 128. so thattheirbehavior is both have the same costs of investment identical. (5) with (5). It then and conversely his investment /k as givenin determining followsfrom (3) that. Stated otherwise.i.uj = = of second-orderconditionsin (4) and fulfillment g'. Player k's reaction functionis symmetrical impliesthatwhen the Nash solutionexists. it is not necessarilytrue that there is a solution because with arbitrary densityfunctionsthe objectivefunctionmay not be concave in the relevantrange. It is solutionexistsprovided that. for playerj aP/luj = aG(gj /Lk)/tL = g(/Lj - into (4) yieldsj's reaction function which upon substitution (W1 . andE(f2) = where Ek Ej.116.t).k) - C' ) = 0. necessaryfora horse race. Increasing marginal cost of skill implies a unique equilibrium spread between the prizes that maximizes expected utility.AOk)and g( ) is a pdf. this implies (W1-W2) a P = prob (qj > qk) = prob (Uj - Ilk > Ek - Ej) - OtFi) = ? and (W1 .E(f) = O.Pj = /k and P Symmetry G (0) = 1/2.RANK-ORDER TOURNAMENTS 845 expected product.C(y)] + (1 .consider the contestant'sproblem. G(-) is the cdf of A.Therefore.).j2 is sufficiently large: possible to show thata pure strategy factor. (jIlk) may be positive.The probability where P is the probability (3) = prob (g j .Ex ante.This resultaccords with Contestsare feasible only when chance is a significant differenceof opinion is and is in the spiritof the old sayingthata (sufficient) intuition = g(lij . Existence of an equilibrium is assumed in all that follows. A contestant'sexpected utility(wealth) is (P)IW1 . each player affectshis probabilityof winning by investing.8 on Mon. verylow levels of investment.C(Z)] = PW1 + (1 . raising expected net earnings. . since he plays against the marketover whichhe has no influence. Each player chooses pi to maximize (2).t4k > G) G (g j . 6 2cr2(because Ej and Ek are i. assuming that C (. implies sharp breaks in the reaction function.).j takes fork.If U2 is small enough the breaks occur at and a Nash equilibrium in pure strategieswill not exist. (4) We adopt the Nash-Cournot assumptionsthat each player optimizes against the optimum investmentof his opponent.g(e).P)[W2 .sinceOP/0. Assuming interiorsolutions.W2)gQ( . so the outcome is purelyrandom in equilibrium.P)W2 - (2) thatj wins is of winning.W2) P2 .

(9.C(g).the worker'sexpected utility at the optimum investmentstrategyis Vpu. or [V .W)](au/(Wi) = 0 i = 1. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . Noting that P = 1/2 in equilibrium. which requires nonnegativityof expected wealth. This contrastswiththe main agency result. The risk-neutral firm'srealized gross receiptsare (qj + qk) V.C'U(j)2g(0) = = Vt + V/2g(O) . (10) The second equality followsfrom V = C'(/i). Therefore. The winningand losing prizes pay off the expected marginal value product plus or minus the entrance fee.like piece rates.k) - V. (6) verifying the point above that players' investmentsdepend on the spread between winningand losing prizes. (8) The equilibriumprize structure selectsW1and W2to maximize(8).C'(. and its costs are the totalprize money offered. Levels of the prizes only influencethe decision to enter the game. Harris and Raviv 1978. in the tournamentas well as the piece rate.846 to JOURNAL OF POLITICAL ECONOMY Substituting .W2)g(0).tk at the Nash equilibrium.Competitionfor labor bids up the purse to the point where expected total receipts equal costs W1 + W2 = condition reduces to equilibrium. = VpL + C'(. and Lazear 1979): W.91.116. The appropriate social investment incentivesare given by each contestant'sattemptto win the gamble.where the bond is returnedto each workeraftera satisfactory performancehas This content downloaded from 128. are efficient and both result in exactlythe same allocation of resources.i + 9. the players receive theirexpected product combined witha fair winnertake-allgamble over the totalentrancefeesor bonds. (9) The marginalcost of investment equals itsmarginalsocial return.k.u)/2g(O) W2 = Vg . But since pj = 9k = g in (7) The expected value of product equals the expected prize in equilibrium.8 on Mon. 2.W1 + W2. Becker and Stigler 1974. Some furthermanipulationof the equilibriumconditionsyieldsan interesting interpretation in terms of the theoryof agency (see Ross 1973.V = C'(g).equation (5) reduces i =j. Substitute(7) into the worker'sutility function(2). Now thinkof the term C'(g)/2g(O) = V/2g(0) in (10) as an entrancefee or bond thatis posted by each player.competitive tournaments. That is.the zero-profit V11= (W1 + W2)/2. C'(p~i) = (W1 .j = .VI2g(O).

however. presenting difficultiesfor standard theorywhere supply factorsshould keep wages in those two occupations approximatelyequal. But q is a random variable. In a one-period contest there is no possibility of This content downloaded from 128. While several other interesting observationscan be made of this sort.because ex ante productsare equal. A contestprovides the proper incentives for skill acquisition prior to coming into the position. while W1and W2are fixedin advance. Yet substantially presidentsare oftenchosen fromthe ranksof vice-presidents. W1. The expected productivity that of a loser is g + E(Ej I qj < qk). This interpretation suggests that presidentsof large corporations do not necessarilyearn high wages because they are more productive as presidents but because this particular type of payment structuremakes them more productive over theirentireworkinglives.91. Since W1> W2is the paymentthat receives never required to induce any investment. equals the payment that k receives. For example. when interpreted in the context of a prize. Nor do wages equal ex post products. Consider ex ante first. It is impossible that the prize is equal to ex ante product. It appears as though the salary of. Even though the optimal prize structuredetermines expected marginal product throughits effecton workerchoice of g and the zero-profit condition (7) implies that expected prizes equal expected producdo not equal tivity. It followsfrom(10) thatthe optimal spread varies directlywith V and oC2. The president of a corporation is viewed as the winner of a contest in which he receives the higher prize.the value of whichis not knownuntilafter the game is played. his salary may triple. It is not a puzzle. On the to presiday that a given individual is promoted fromvice-president dent. Consider the salary structurefor executives.116. there is additional informationfromknowing the identity of of a winner is g + E(Ej I qj > qk).but rather because it induces that individual and all other individuals to performappropriatelywhen they are in more junior positions. It is difficult to argue that his skillshave tripled in that 1-day period. while winnersand losers. Only under the rarest coincidence would W1 = Vqj and W2 = Vqk. Since gj = 9k= a.we note a somewhatdifferent but important practical implication of this general scheme.RANK-ORDER TOURNAMENTS 847 been observed. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . There the incentive mechanism works through the employee's attemptsto work hard enough to recoup his own bond. neverthelessactual realized earnings definitely productivity in either an ex ante or ex post sense.3 3 If E is a fixed effect. Comparative staticsfor this problem all follow from (9) and (10) once a distributionis specified. expected productsare equal.8 on Mon. His wage is settledon not necessarily because it reflects his currentproductivity as president. Here it works through the attemptsto win the gamble. if E is normal with variance _2. the vice-presidentof a particular corporation is below thatof the presidentof the same corporation. theng(0) = 2uV'cr. say. Actual product is Vq rather than Vtk.

Since all these schemes involve the same investmentpolicy.It is not difficultto show that this does not affect the general nature of the bond-gamble elements or firmsadopt if the investmenthas firm-specific solution. is dropped. Using the same methodsas above. an ordinal scale is "weaker" and has fewerrequirementsthan a cardinal scale.The essential point follows from the theory of measurement (Stevens 1968) that a cardinal scale is based on an underlyingordering of objects or an ordinal scale. Alternatively. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .whereas corporate executives.we have demonstratedthe surprisstitutions ing resultthatboth achieve the Pareto optimal allocation of resources when workersare riskneutral. In a modern.the same expected utilityto workers.typically whose output is more difficult to observe. This is also true of contestsamong can be chosen to achieve the optimal investment. a workermightbe compared witha fixedstandard q.4 In spite of the apparent equality of these schemes in termsof the preferences of risk-neutralworkers. these restrictions apply. Salesmen. For example.and since average payout by the firmequals average product forall of them.theyall yieldthe same expected rewardsand. Attempting to as attempting to beat beat the standard has the same incentiveeffects another player.WithN contestants. since for anyq a correspondingspread 4The level of the standard is indeterminate. or some combination. the informationwould be valuable and would constrain subsequent wage paymentsin successive rounds through competitionfrom other firms.91.Yet the costsof measurementfor taking advantage of this information.However. On the other hand.2 of them are indetermimore than two players. it is not difficult to show thatthere are spread-standardcombinationsthatinduce Pareto optimum investments. then tournamentsdominate piece rates and standards. In that sense. withone payment and another. a person's productivityas chief executive officer is measured by his effect on the profitability of the whole enterprise.8 on Mon. higher. whose output level is easily obare paid by piece rates. engage in contests. instead of playing against an opponent. served. occupations for which output is easily observed save resources by using the piece rate or standard.116. nate. In factother schemes also achieve this allocation. do not necessarily policies thatbind workersto it (as in Lazear 1979).848 Comparisons JOURNAL OF POLITICAL ECONOMY indifferent Though tournamentsand piece rates are substantially for creatingincentives. payawarded if output falls anywhere below _q mentawarded ifoutput fallsanywhereabove standard. complex business organization. the indeterminacyvanishes in both cases. in a sequential contest with no firmspecificcapital. considerations of differential and measurementmayserve to break thesetiesin costsof information practical situations. therefore. When risk neutrality This content downloaded from 128. the prizes of N . and avoid the necessityof making directcomparisons withothers as the tournamentrequires. If it is less costlyto observe rank than an individual's level of output.

For example. Then the firm's(track) revenue function few order statistics. spectatorsat a horse race and both possibilities generally are interestedin the speed of the winning horse and the closeness of the contest. (fastest)order statistic. the sorting is by anticipated marginal products. The point is that such tests are inherentlyordinal in nature. In that sense.8 on Mon. etc. Galton proposed it on strictly grounds. If it can be accomplished. The revenue functionitselfcan even involve rank-orderconsiderations. there exists the possibilityof paying workers either on the basis of individual performanceor by rank order.91.116. yetthe horses could be paid depends on the first on the basis of theirspeed ratherthan on the basis of win." These issues are more thoroughlydiscussed below.Realizations fromsuch testsare sample statistics in these assessments. for that matter)who are known to be of higher quality ex ante may play in games with higher stakes. In the statistics there is an early paper by Galton (1902) that is worthyof brief and second-place discussion.assuming the prizes were divided in the followingratio: W11W2= (Q1 .5 of the problem of tournament There has been verylittletreatment prize structureand incentives in the literature.Q3). and show positions.place. pay differencesamong contestantsof known quality resemble the effectof a "piece rate. It is in situationssuch as this that the conditions seem ripe for tournaments to be the dominant incentive contract institution.in much the same way that grades are assigned in a college classroom and IQ scores are determined. This content downloaded from 128. Notice in this connection that the basic prize and piece-rate structuressurvivea broad class of revenue functionsotherthan summable ones. it each conceivable candidate are prohibitively mightbe said thatthose in the runningare "tested"by assessmentsof performanceat lower positions. Instead. cardinal ratio scale. contests. even though the profitability of the enterpriseis meteredby a well-defined. Here Qi is the expected value of the firstWhile a moment'sreflection suggeststhis criterionto be roughlyrea priori lated to marginal productivity.Q3)/(Q2 . Even if the production functionof the firmincludes complior substitution among cated interactionsinvolvingcomplementarity individual outputs. In the real world. stillexist. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . Both methods would induce them to run fast.RANK-ORDER TOURNAMENTS 849 expensive.Little else but the well-knownpaper by Friedman (1953) based on Friedman-Savage literature preferencesforlotteriesexistsin economics. Galton inquired into the ratio of firstprize money in a race of n contestants. marketparticipantsare sorted into different where there is population heterogeneity.He wenton to show the remarkableresultthatthe ratioabove 5The reader is reminded that throughout this section and the next workers are identicala prioriand differ onlyex post throughthe realizationof E.There players (and horses.

Olkin.116. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . Galton's original work and the more modern developments it has given rise to are not helpful to us. A piece rate is a linear transformation of output.Differentutilityfunctions 6 One might think that risks could be pooled among groups of workers through sharing agreements. An alternativedesign is a knockout tournament withsingle or double elimination. Hence. thiscriterionresultsin a highlyskewed prize structure. Gibbons. Optimal Compensation with Risk Aversion All compensation systems can be viewed as schemes which transform the distribution of productivity to a distribution of earnings. because the interaction between insurance and action implies substantially different first in the two cases. A tournamentis a highly nonlinear transformation:It converts the continuous disinto a discrete. Truncation offeredby prizes implies more control of extreme values than piece rates but less control of the middle of the distribution.91.850 JOURNAL OF POLITICAL ECONOMY is approximately3 when the parent distribution of speed is normal. but does not generate as much information as the round robin (David 1963. both schemes yield identical investments and expected utility because their first momentsare the same.the method of paired comparisons has tournament-likefeatures.binomial distribution of intributionof productivity come. so the reward structureis irrelevantfor resource allocation. a skewed reward structurebased on order statistics is less surprising for virtuallyany parent distribution. A worker would never agree to share prizes since doing so would resultin . This content downloaded from 128.it is shown thatwithriskaversionone method or the other usually yields higher expected utility.The problemwe have treatedhere is thatof choosing the reward structure to provide the proper incentiveand elicitthe sociallyproper distributions.but we show some examples here.From what we know today about the characteristic skew of extreme value distributions. and the object is to choose the one with the largest mean. theydeal withsamples fromfixed populations.8 on Mon. and consequentlyE(qj + qk) = 0 and bankruptcy forthe firm. III. Samples from differentpopulations are compared pairwise.u = 0. When workers are risk neutral.In the more modern statistical literature.but that is false because of moral hazard.so the distribution of income is the same apart froma change in locationand scale. In thissection.As a result. and Sobel 1977).6 and second moments of the income distribution We have been unable to completely characterize the conditions under which piece rates dominate rank-ordertournamentsand vice versa. Comparing all samples to each other is like a roundrobin tournament.The latterrequires fewersamples and is thereforecheaper.firms tournamentsor piece rates offering in the pure sense yield higher expected utilitythan the sharing arrangement.

the worker's problem is maxE(U) = f U[I + rp.C() = (11) (12) - I + rp.Therefore. 0. Linear Piece Rate7 Optimum The piece-ratescheme analyzed pays workersa guarantee. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . I combination that maximizes workers' expected utility max [E(U) = maxf U(y)6(y)dy]. A more general structurewould allow for nonlinear piece rates (see Mirrlees 1976). the optimum contract Solving (14) for I and substituting maximizes f U{Vg(r) + rE.8 on Mon. Aftersimplification 7 The following is similarto a problemanalyzed byStiglitz(1975). The problem for the firmis to pick an r. ( 14) V.116. + The first-order condition is 9E(U) = f [U'(y)][r.C'(It)]f(E)dE ~49 which convenientlyfactorsso that r = C'(Q).RANK-ORDER TOURNAMENTS 851 weight one aspect more than the other so that tournaments can actually dominate piece rates.C[g(r)]}f(E)dE the withrespectto r. the zeroprofitmarketconstraintis = I + rgu. A linear piece-rate structure is a simplification.t = . rq. The worker'sproblem is to choose tkto maximize expected utility given I and r. where .u(r)satisfies (13). = rE -C (g)]f (E)dE. Assuming risk-neutral employers.Vgtis expected revenue from a workerand I + rg is expected wage payments. If E f(E).wherer is the piece rate per unit of output. (13) Condition (13) is identical to the risk-neutral case. plus an incentive. g.I. where y =I + rq .(A into (12).91. This content downloaded from 128.+ rE C(k) and 0(y) is the pdf of y. because E is independent of investmenteffort.

the Nash solutionimpliespi = gk 8 Furthermore. The same is true of the approximations below for the tournament. but an increase in 0-2 actually reduces variance. (18) where * denotes the outcome of the contestratherthan the piece-rate scheme. (15) shows thatV > C'(pu) in the is optimum contractfor risk-averseworkers. and C" have correspondingeffects the variance of income (see [17]). r-V/(1 + sC"o-2) and I-sV2o-2/(1 + sC"o2)2.if 0-2 is large. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . All these approximationsuse first-order expansions for termsin U'( ) and second-orderexpansions fortermsin U( ). function Using familiarTaylor series approximationsto the utility and a normal densityfor E. because it reduces r and increasesJ*8 Prize Structure Optimum in a two-playergame is The worker'sexpected utility E(U) = P{U[W1 - C(tk*)]} + (1 - P){U[W2 - C(tk*)]}.so thatr = V andI = 0 in the case of riskneutrality (s = 0).116. The optimum prize structureis the solution to max (E(U*) W1 sW2 = max{P * U[W1 - C(Q*)] + (1 -P) U[W2 -C(W)]}) (19) constraint subject to the zero-profit V11* = PW1 + (1 .i. Investmentincreases (see [16]) in V and decreases in s. (20) The workerselectsg* to satisfy oE(U)/h. (15) Since riskaversion impliesEEU' < 0.852 marginal condition is [V - JOURNAL OF POLITICAL ECONOMY C'()] d_ EU' dr + EEU'= 0.This underinvestment the moral hazard resultingfrominsuranceI > 0 and r < V implied by (15). s. and 0_2.* = 0. because all these changes implysimilarchanges in the marginal piece rate r which influencesinvestment throughcondition on (13).91.8 on Mon.. Since cost functions are the same and Ej and Ek are i. the optimum is approximated by c'-1 ( 1 + sC"o-2) and 0_2 202 (1 + sC"o-2)2 (16) (17) ( -U"/U' evaluated at mean income is the measure of absowhere s lute riskaversion.P)W2. The same changes in V.d. C". This content downloaded from 128.

C'(p.C(. Again.U'[WT C(.*)]forT Equation (21) implies /I= 1*(W.C (/i*) ifq j ye = W2 .C (. but the problem is significantly more complicated than that because there is no separation between tastesand opportunitiesin this problem: The optimum 9 Futhermore. withP = '/2. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .RANK-ORDER TOURNAMENTS 853 and P = plifiesto '/2 as before.91.2 in excess of 1/sC"\/.N(0. second-order approximations yield . (22) (23) 2[U(l) .W2).Ek) = 0. lower. This content downloaded from 128. The comparative staticsof (24) and (25) are similarto the piece rate (16) and (17) and need not be repeated..*)] + 1/2U[W2 -C(9*)] subject to (20).*) ifq j > < qk qk and E j. 2.Ek.W2)maximizes E(U*) = 12 U[W1 .i (1 + ITCrsC o-2)2' (25) (5 where = W. and cov (Ej. Increasing marginal cost of investment and risk aversion guarantees a unique maximum to (23) when a Nash solution exists.8 on Mon. the variance of income in the tournament is smaller than for the piece rate.*) . Then the worker's investmentbehavior simC' (u* (21) (1 = 1.116.and (22). Comparisons Equations (16) and (24) indicate that investmentand expected incomel0are lower forthe contestthan forthe piece rate at givenvalues of s.g(O)(W1 . so the spread is stillcrucial for investment case.uimplieslowerybecause revenue fallsbymore than cost. .as in the risk-neutral 10Since y = Vu level of u when CQ(g).Cr-l (1 and 2 V ) (24) V 7rVOfr.and since .U(2)]g(0) U'( 1) + U'(2) where U(T) UIWT .N(Oo2). This would seem to suggest that contests provide a crude formof insurance when the variance of chance is large enough.W2). incentives.o-2).C(p*)] and U'(r). assuming a normal densityforE. Moreover.u is below the wealth-maximizing workersare riskaverse. for values of o. and the optimum contract(W1.

011925 5.514282 F.9846 .012150 5.9878 . However.020 5.C (?) This content downloaded from 128.so an amount of nonlabor income yo is assigned to the worker to avoid a major approximation error of the normal. the contestis only preferredfor a2 < .5741 2.2 ? 3.012445 5.9142 .9960 .91. when there is declining absolute risk aversion.9975 . Again quadratic costsand normal errors are assumed.9807 . Thus.9922 .8 on Mon. which exhibitsconstantrelativebut declining absolute riskaversion. this utilityfunction is defined for positive incomes only.011800 5.012465 5.9980 .-U a2. However. while contestsplace 50 percentof the weightat one value significantly below the mean and the other value significantly above..e.011940 5. for the constant. the contestis preferred until o.116.012295 5.011420 5. the possibility of losses).523437 2. which admits negative incomes (i.5. absolute risk-aversionutility functionU = -e-slYs. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .020. if yo = 25 so that s = .005 E(U*) .524237 2.010515 .9995 .1 .524725 2.524665 2.However. Strongly risk-averse workersseem to dislike the binomial nature of thisdistribution when too much of the mass at low levels of 0J2 is high because it concentrates utility. V = 1. s(y0)= .9938 .s(y) = (1 . However.011415 5.9984 .y =yo + W -C(yA) forcontest(i = 1.a)Iy. when o-2 is small.005.a = . for example. The intuitionis that piece rates concentratethe mass of the income distribution near the mean.9950 . we have examples where the contest dominates the piece rate.012100 5.519930 2. the insurance provided by the contest is insufficient to compensate foritssmallermean: It can be shown thatthe of the optimal piece rate exceeds that of the expected indirectutility optimal tournamentfor all values of o.y ye +I +rq -C(y)forpiecerate.524575 2.9436 .2 1 12 No] p/2: .5 1 3 6 12 . s(y0)= .854 JOURNAL OF POLITICAL ECONOMY mean and variance themselvesdepend on utility-function parameters.9552 . Table 1 shows that when yo = 100 so thats = .9710 . ay'. Illustrativecalculations are shown in table 1 using the utility function U = aya.1 .2.524616 2.9419 .8094 = . at least withnormal distributions and quadratic investment-cost functions.9852 .8420 Yo = 25.2.the contestwhichtruncatesthe tails TABLE 1 CONSTANT '2 RELATIVE RISK AVERSION yA* E (U) Yo = 100.012155 5. 2).

It is positively skewed because Vp. Persons in the risk-averse region are assigned to occupations in which income follows productivity. IncomeDistributions While it is not possible to make a general argument based on an example. which is smaller for workerswho select contests. The reason is thatyo and mean-wage income are posicorrelatedbecause the likelihoodof choosing a contestincreases tively withyo.9807.012100) and the poor preferpiece rates (2. and face the same costs and luck distribution.523437). The Friedman-Savage utilityfunction implies that a person's risk This content downloaded from 128. 1). Individuals will self-selectthe paymentscheme in accordance withtheirwealth.9846 exceeds p. if o-2 = 1 then the rich prefercontests(5. it can be optimal to pay piece ratesto those withsmall values of endowed income and to pay prizes to those with large values.116. the only difference being the fact that some workers have larger endowed incomes than others.91. who studied how alternativesocial thatcater to workers' arrangementscan produce income distributions risk preferences.Note that .If thisdifference is large enough. and A* depend upon s(y).* > Vp. This situationis shown in figure 1. weighted by the number of individuals in each occupation (see fig..such as the one in table 1.8 on Mon.524237 > 2. The overall distribution is the sum of a binomial and a normal with lower mean.It is binomial with mean Vp)* and variance (AW)2/4for those who enter tournaments. The overall is the sum of these two and exhibitscharacteristic distribution skew.RANK-ORDER TOURNAMENTS 855 of the income distributionassociated with a linear piece rate has higher value. . table 1 suggests that persons with more endowed income and smaller absolute risk aversion are more likelyto prefercontests. for example. and those withlow levels of endowed wealth and larger absolute risk aversion are more likelyto preferpiece rates.012295 > 5. and it can turn out as it does in table 1 thatexpected income is larger in the contestthan in the piece rate. Note also that the distribution of wage income will be less skewed than that of total income. These implicationsconform to the standard findingson the distribution of income in an economy. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . Consider a situationin which all persons have the same utility function. but /* = . He showed that the Friedman-Savage utility function leads to a two-classdistribution. while persons in the risk-preferring ticketsin very region buy lottery riskyoccupations in which few win very large prizes. The distribution of earnings among those selecting the piece-ratejobs is normal with mean Vg and variance r2o-2. This example is interesting because it is verycloselyrelated to some early resultsof Friedman (1953).

5. Suppose the output estimatorforworkeri in activity T is qi= qir + pT + PiT.91.but common to all workerswithin errorthatis specificto activity that activity. That is. + Vp Y.116.justas in our example. where viT is random error and p. is an i.In the piece rate the common error p adds noise which risk-averseworkersdislike. while the common noise drops out of a rank-ordercomparison because it affectsboth contestantssimilarly.but the error structure plays additional roles when workersare riskaverse. Second.This is similarto monitoringall workersby a mechanical count- This content downloaded from 128. while thatfor the piece rate is o-2 + o-2. Therefore. However. the relevantvariance for the contestis 2o-2. workersin this model are risk averse for all values of incomes. It is evident thatthiscan tip the balance in favor of tournamentsif o-2 is large enough and/or workersare sufficiently risk averse. The common error p bears two interesting interpretations. but even so gambles can be the optimal policy. Error Structure Relative costs of measurementare stillimportantin choosing among incentiveschemes. Z+Y( W FIG. One is activity-specific measurement error.First. Friedman's assignment of people to jobs really follows endowed wealth(yo).8 on Mon. For example.856 f(y) JOURNAL OF POLITICAL ECONOMY . our framework offerstwo improvements.the problem of incentivesis directly incorporated into the formulationof the optimum policy. 1 yO+VtL* W1+yO Income preferences depend on the part of his wealth that is not at risk. j and k may have the same supervisorwhose biased assessmentsaffectall workerssimilarly. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .

some formof truncation is desirable.116. using a contestagainst a fixed standard q discussed above has lower variance than playing against an opponent. however. It must be pointed out that. But thisleads us back to the problem of common error. we might expect risk-averseworkers to prefer absolute standards.in the absence of measurementerror. the relevant variance in a contest is that of ( = Ek .The other interpretation of p is true random variation that affectsthe enterpriseas a whole.the crucial issue is the costs of measurementand the error structure. and wages based on a contesteliminatethis kind of variation. suppose all firmsproduce with the same technology.8 on Mon. Heterogeneous Contestants but ratherseem to Workersare not sprinkledrandomlyamong firms be sorted by abilitylevels. That to be paid I ifq < q and lo + rq forq -q. This is important schemewould allow workers because it truncatesthe possibilitieswhen Vq < 0.it bears repeatingthatthese are inherently ordinal in nature. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .RANK-ORDER TOURNAMENTS 857 ing device that mightrun too fastor too slow in any given trial." It is clear thatusingstandardsas well as piece ratesmustbe superiorto using one alone. but that in a given period some firms do better or worse than others.91.it is possible thatverylarge negativevalues of output can occur.it is difficult to observe output and thereforedifficult to compare to an absolute standard. it is difficult productioncircumstances to know whetherthe person failed to meet the standard because of insufficient investment or because the firmwas generallyexperiencingbad times. This content downloaded from 128. Given the technology. One explanation for this has to do with complementaritiesin production. Consequently. As shown in Section II. IV. Insofar as samples and testsare necessary."1Again.Ej. Informational considerations imply that 11 Playingagainst a standard is like Mirrlees's(1976) notion of an "instruction. But even in the absence of complementarities. A contestis an alternativeway to control the tails of this distribution. which has variance 20-2 against an opponent and only o-2 against a standard (since the standard is invariant. Ek 0). Then risk-averseworkers prefer not to have their incomes vary with conditions facing the firmas a whole. and since it is impossibleto always tax workersthe fullextentof thisloss.For the complex attributesrequired for managerial positions.where it is often impossible to know whethera person's output is satisfactory without comparisons to other persons.sorting may be an integral part of optimal laborcontract arrangements. For example. when there are changing in the firmas a whole.Withoutits eliminationthere would be excessive losses due to moral hazard. a problem of measuring "value added. Further." Risk-averseworkersincrease utility by competingagainst an opponent and eliminating thiskind of firmeffect.

" Instead. Recall thatPi depends on the individual's level of investment and thatof his rivals. Firms select their employees based on such informationas past performances. Firstwe show that players do not self-sort into a leagues and b leagues. a's and b's. Recalling from(6) and (9) that = V/g(O)and from (10) that W' = VI* . b. Playersdo notself-sort. The next section discusses handicapping schemes when all cost-function differencescan be observed by all parties. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . all workersprefer to work in firmswith the best workers(the major leagues). withmarginal < CQ4) forall costsof thea's being smallerthan those of the b's: CQ(pu) of disturbancesf(E) is assumed to be the same for pt. and similarly forpu. Therefore.The distribution both groups.91.116. thissectionreturnsto the case of riskneutrality and analyzes tournamentstructureswhen investment costs differamong persons.858 JOURNAL OF POLITICAL ECONOMY compensation methods may affectthe allocation of worker types to firms.a*).there is no pure price-rationing mechanism that induces Pareto optimal self-selection. Then (26) Ri(pu)= Wi + (WI.pa = G (IL -E*) and pb = G (a .) = Vg* V0)[1/2-G ( - g*)].Therefore. Therefore. (27) This content downloaded from 128.and Pi is the probability of winning in league i. The principalresultis that the a's and b's do not self-sort into theirown "leagues. tournamentstructuresnaturallyrequire credentials and other nonprice signals to differentiate people and assign them to the appropriate contest.. Two typesof persons are assumed. 1. we show that the resultingmixed leagues are inefficient.The following section addresses the question of self-selection when workersknow theiridentities but firms do not. But mixed play is inefficient because it cannot sustain the proper investment strategies.8 on Mon. where V = C'(/u4*). where ua* is the existingplayers' investments in the a league. where (Wi . i = a. Adverse Selection Suppose that each person knows to which class he belongs but that thisinformation is not available to anyone else. Furthermore. -Assume leagues are separated and consider the expected revenue Ri generated by playingin league i = a.equation I(26) becomes Ri(. Second.if the a's and b's draw from differentdistributions. Many of the following results continue to hold.W12) is the prize money. b with an arbitrary investmentlevel g.V12g(0).W)Pi. with usually obvious modification of the arguments. The proof of adverse selection consistsof two parts. and some are not permittedto compete.

2 This content downloaded from 128.a). are inefficient.The first-order condition for investmentof type i in this game is a L + a+(l-a) a a) i i . Therefore. Furthermore.u*) = V.independent of cost curves. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .RANK-ORDER TOURNAMENTS 859 Note thatRi(p) = VAlu when . So Rb(.W2) is the prize money in mixed play and Pj7is the probability thata player of typei defeats a player of typeJ. thentz* < a* so that . 2. then expected utility W2 + [aPr + (1 . = and thatdRi/dpu R2'(Q) = Vg(p. Since R=*) Ri'(t) < V elsewhere.) is increasing. Rj(1_0) Rb[1.the revenue functions never cross.116.8 on Mon. Therefore. Since CQ(*) > Ri(Ipc). Mixedcontests -Suppose the proportionsof a's and If pairingsamong b's in the population are a and (1 .( WI ] * - - W2) = Ci' 1i) A development similar to Section II implies equilibrium reaction functions [ag(0) + (1 - a)g(ia -. where (W1.and sinceRi(. 2).u*)/g(O) > 0.91.a)P'](W1 .U) lies to the southwestof Ra(pu)(see fig.b)](WI W2) Ca(ja) Rj(p) Vfl R ib 2 FIG. = R'(pi). = V and C'(. -(qa* -(l)] V fork = p* and Rb(pu) is a pure displacementofRa4L).W2) - Qbi).it is alwaysbetterto play in the a league than the b league: Workers will not self-select. of a player of typei is a's and b's are random. respectively.

productionis additive. for some high levels of [L. W7 . where 6i is an unobserved ability component forplayeri and q is white noise. but the cost is thata's overinvest. the case where a's want to prevent b's from contaminatingtheir league.Similarly. Rothschildand Stiglitz(1976). Riley (1975). it is more profitable to play in the a league and. > E(5k qjil > qkl) This content downloaded from 128. which ag(~i2b -a) + (1 -a)g(O).116. for example. but only at a cost. We conclude that a pure price systemcannot sustain an efficient competitiveequilibrium in the presence of population heterogeneity withasymmetric information. only briefly First. mixed contestsyield inefficient investment:One type of player overinvestsand the other underinvestsdepending upon whether or not a ] l2. By making the spread. thisconditioncan hold onlyifa = 1/2. sorting may well be crucial. so it does not matterwho works withwhom. except in thatveryspecial case. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . Suppose it is efficient forthe individual withthe highest8 to be the chief executive. Suppose that qit = pi + 8i + qit. Ra(4) becomes steeper than Rb(4) in figure2 and crosses it so that the envelope covers Rb(Q) at low values of p and Ra(IL) at high values. but.8 on Mon.V2. the b league is preferable. then Cb'(Qb) = V implies ag(O) + (1 .a)g(O)](Wi - W2) Cb'Vb) = for b's. Marketscan be separated. a separating equilibrium need not exist. and Wilson (1977).Therefore.Individuals may self-sort.In thispaper. A series of pairwise. The result is akin to that of Akerlof (1976) and to those of Spence (1973).ua).a)g(ji. thatequilibriummay be inferiorto a nonseparatThe obvious practical resolution of these difficulties is the use of nonprice rationing and certification to sort people into the appropriate leagues based on past performance. even if it does. To the extent that the production technologyis somewhat more complicated. firmsuse nonprice factorsto allocatejobs among applicants..86o for a's and [ag (jib -') JOURNAL OF POLITICAL ECONOMY + (1 . Then. If the solution is efficient. forlow levels of p. The rules for allocating thosejobs may be importantfor at least two reasons thatwe can describe here.91. There will be a tendency to have winners play winners because E(8j I qjl > qkl) ing equilibrium. sufficiently large.a -/b) Ca(. Since g is symmetric and nonuniform.sequential contestsmay efficiently perform that function. Consider.sortingworkersof different skilllevels into appropriate positionswithina hierarchy maybe beneficial. As they show.

The spread is larger in mixed than pure contestsunless a This content downloaded from 128.8 on Mon. Competitivehandicaps yield efficient Consider again two types a and b now known to everyone.91. cost-efficient Second. and the prizes in a mixed league by W1and W2.) h)i\W= (28) and g (-a lib- CG(b)- of g[~I) Since (The second condition in [28] followsfrom symmetry = criterionis V C'(. Therefore.h). namely.their Denote the sociallyoptimal levels of investment difference by AA. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .116. the optimum spread in a mixed match must be = V/g(A/.A worker who is ignorant about his cost functionvalues information before selecting a level of investment expenditure.one can imagine the existence optimal investment of firms which specialize in running contests among young to be used workers-the minor leagues-which provide information when and if the workersopt to increase the stakesand enter a bigger league.u*) = C'(.RANK-ORDER TOURNAMENTS 86i in the firstround.a piece rate alwaysyieldsan asymmetric However. once slotefficient solution. in productingof workersis importantbecause of complementarities about their tion. everyone.u*). workersmay not know preciselytheirown abilitiesor cost functions. firmsmay offer "tryouts"to provide informationabout strategies. These issues point up an importantdifferencebetween piece rates and contests. independent investment the efficient of pairings.V = CA( = G(b).Let h be the handicap awarded to the inferiorplayer b. Prize (11) and (12) are structuresin a-a and b-b tournaments satisfying but those conditions are not optimal in mixed a-b play. by /ua*and /4*. or if it is desirable for workersto gain information type.it is no longer obvious that a series of sequential contestsdoes not result in a superior allocation of resources.In fact. condition (29) insures the proper investmentsby both contestants. Handicap Systems This sectionmoves to the opposite extremeof the previous discussion and assumes that the identitiesof each type of player are known to mixed contests.u . A sequential elimination tournament may be a way to select the best person. In the pure heterogeneous case. efficient. Then the Nash solution in the a-b tournamentsatisfies -~a -ab h)AW = QA. A JW (29) From (28). where informationis and workersare riskneutral.

Ct(a*)] (30) = pW1 + (1 -P)1/V2 . paying W1 . since h* = LAtI2 < Ag. In thiscase. then Ya is positive and a's preferto play in mixed contestsratherthan withtheirown type. + W2 = V * (qu* + g4) independent of h since the spread is alwaysadjusted to induce investments and /1t*. The a's are given a competitive edge in equilibrium. A two-playergame is said to be fair when the players are handicapped to equalize the medians. The competitivehandicap does not result in a fair game. then LA.h)](A constraintreduce (30) to the zero-profit Ya(h) V .W2 + /3 the investments unaltered.because theycontributemore to total output in mixed matches than the b's do. therefore. If the actual handicap is less than h*. With no handicaps.h) is the probability wins the mixed match.so the gain to a decreases in h. the appropriate spread is a decreasing functionof h.while b's prefer to play withb's only.ib*.because expected returnsare equal between segregated and integratedcontests for each type of player.t = /4*. Therefore. to b's. Otherwise. and W2mustalso satisfy the zero-profit constraint W. different Alternatively. gua* The gain to an a from playing a b with handicap h.8 on Mon.91. wage schedules would clear the market. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions .(Wal + Wa2)/2. / -) h (32) The expression foryb(h)is the same. thata whereYa(h) is the gain to a and P = G (A . (31) The zero-profit constraintsin a-a. The corresponding expression for b is Yb(h) = (1 . a-b. is the differencein expected prizes: ya(h)= PW1 + (1 -P)W2 - C(La*) -2[(Wy + Wa)/2 .h* = gI/2is the competitivehandicap. This same result holds if Ea variance than Eb. It is easy leaves the spread and.3 to a's. between mixed and pure to verify thata's and b's are stillindifferent contests. and the gain to b increases in h.lit is .(Wbl+ Wb2)/2. This approximation and small and P l/2 + [g(4g . rather than another a with no handicap.3 and W2 . but it may be sensitiveto the assumphas a different tion of statistical independence and output additivity. Since Ya(O) = -Yb(O) 3. since it impliesya(h*) = yb(h*)= 0. The gain of playingmixed matchesto a is completelyoffsetby the loss to b and vice versa.116. If Ca(11) is not greatlydifferent fromCb(U). Prizes W.P)W1 + PW2 . except its sign is reversed. The opposite is true if h > h*.h). the market-clearing prizes available to a's in the mixed contestare lower This content downloaded from 128.862 JOURNAL OF POLITICAL ECONOMY gives b the full handicap h = a* . while paying W1 + /3. h can be constrainedto be zero. and b-b require that ya(h) + yb(h)= 0 forall admissibleh.

Armen A.low-qualityworkers attemptto contaminatefirms composed of high-quality workers.J. Depending on the utilityfunctionand on the amount of luck involved.RANK-ORDER TOURNAMENTS 863 than those faced byb's. Compensatingworkerson the basis of their relative position in the firmcan produce the same incentive workers as does the optimal piece rate. This complication adds an importantresult: Competitivecontestsdo not automatically sort workers in ways that yield an efficient allocation of resources when informationis asymmetric.E. one scheme is preferred to the other. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . Contaminationresults in a general breakdown of the efficient solution if low-quality workers are not prevented from entering. Still. when player types are known to all. 90 (November 1976): 599-617.even if there are no complementarities in production. Under certain conditions. The b's are given a superior schedule in the mixed contest as an equalizing differencefor having to compete against superior opponents. V. This yields the surprisingconclusion that reverse discrimination.8 on Mon. Alchian. there exists a competitive handicapping schemewhichallows all typesto workefficiently within the same firm. This content downloaded from 128.91. "The Economics of Caste and of the Rat Race and Other Woeful Tales. and Economic Organization. It structurefor risk-neutral might be less costly." Q. "Production. InformationCosts. Finally. When riskaversionis introduced. to observe relative position than to measure the level of each worker's output directly. An advantage of a contestis thatit eliminatesincome variationwhichis caused by factors common to workersof a given firm.a scheme which rewards rank yields an allocation of resources identical to that generated by the efficient piece rate." A. Summary and Conclusions This paper analyzes an alternativeto compensationbased on the level of individual output.This results in paying salaries which resemble prizes: wages which differ from realized marginal products. References Akerlof.because their probabilityof winningis larger.George. and Demsetz.R.we allow workers to be heterogeneous.the prize salaryscheme no longer duplicates the allocation of resources induced by the optimal piece rate.In particular. 62 (December 1972): 777-95. Harold.E. where the less able are given a head start or rewarded more lucrativelyif they happen to accomplish the unlikely and win the contest. can be consistentwith efficientincentive mechanisms and mightbe observed in a competitivelabor market.116.expected wages are higherfora's than b's in the mixed contest.however. However..

A. Statistics."J.. 1968): 849-56.John G. and Sobel. 90 (November 1976): 630-49. Olkin.E." Q. London: Charles Griffin. Harris. Jean D. 63 (May 1973): 134-39. Econ. "Competitive Signalling.R."J. S.Health Insurance. Theory10 (April 1975): 174-86. Chicago: Univ. Rothschild."J. "Incentives. Milton. 68 (March 1978): 20-30. 61. Ross.. Milton." BellJ. "Equilibrium in Competitive Insurance Markets:An Essay on the Economics of ImperfectInformation.E. TheMethod ofPaired Comparisons. "Law Enforcement. Herbert A." A. 16 Sep 2013 11:04:40 AM All use subject to JSTOR Terms and Conditions . and Compensation of Enforcers. Steven N. Gary S. S. Stephen A. Chicago Press. 4 (August 1953): 277-90."J. 161 (August 30. "The Economic Theory of Agency: The Principal's Problem. David. no. Econ. Milton. "Measurement. 87. and Ordering Gibbons. "The Optimal Structure of Incentives and Authority withinan Organization. Theory16 (December 1977): 167-207. "Choice. 1977. no.P."Some Resultson IncentiveContractswith Applications to Education and Employment. This content downloaded from 128. Legal Studies3.E. and Stigler.Riskand Information:Notes towardsa Theory of Hierarchy. Friedman.E. Papers and Proc. Chance. Spence. Michael."A.Joseph E. "The Most Suitable Proportion between the Values of First and Second Prizes. Francis." Biometrika 1 (1901-2): 385-90. Joseph E. 87 (August 1973): 355-74.George J.Econ. New York: Wiley. 6 (December 1979): 1261-84.E. Michael. 1963. "Why Is There Mandatory Retirement?"J. and Law Enforcement. and Stiglitz. Galton.J. Lazear.Malfeasance. Wilson. no. Edward P." Science Stevens.James A.R. 1 (1974): 1-18.864 JOURNAL OF POLITICAL ECONOMY Becker. Cheung. 1969.and Raviv. 7 (Spring 1976): 105-31. and Management Sci."Bell J. Riley. Stiglitz. Econ." Q. The Theory to of Share Tenancy:WithSpecial Application Asian Agriculture and theFirstPhase of Taiwan Land Reform.91.J.E. Selecting Populations: A New Statistical Methodology. Ingram. and the Personal Distributionof Income. and the Schemapiric View. 6 (Autumn 1975): 552-79.8 on Mon. S.Artur.116. Charles A.P. Mirrlees. "A Model of Insurance Markets with Incomplete Information. "Job Market Signaling.