DO TOURNAMENTS SOLVE THE TWO-SIDED MORAL HAZARD PROBLEM?

Abstract The paper analyzes the optimality of relative performance evaluation via two-part piece rate tournaments in incentive contracting with multiple agents and two-sided moral hazard. If the agents are risk-averse, it is shown that a tournament is optimal only when the following conditions hold: (i) there is common uncertainty inflicted on the activities of the agents that is not contingent on their actions, but can be contingent on the principal’s action; (ii) the principal sufficiently saves in transaction costs by employing a tournament; (iii) the number of agents is sufficiently large. Then the feedback effect of using a tournament to monitor the agents is that the principal’s moral hazard problem is relaxed when the principal takes a single action. It can also be relaxed when the principal can vary her actions with the agents but there are economies of scale in her activity. Absent common uncertainty, the optimum scheme is shown to be a fixed performance standard, rather than a tournament, but if the agents are risk-neutral, a tournament can still be optimal provided that (ii) and (iii) hold.

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