Rank-Order Tournaments as Optimum Labor Contracts

Abstract

It is sometimes suggested that compensation varies across individuals much more dramatically than would be expected by looking at variations in their marginal products.This paper argues that a compensation scheme based on an individual's relative position within the firm rather than his absolute level of output will, under certain circumstances, be the preferred and natural outcome of a competitive economy.Differences in the level of output between individuals may be quite small, yet optimal "prizes" are selected in a way that induces workers to allocate their effort and investment activities efficiently.In particular, by compensating workers on the basis of their relative position in the firm, one can produce the same incentive structure for riskneutral workers that the optimal and efficient pie~e rate produces.It might be less costly however, to observe relative position than to measure the level of each worker's output directly.This results in the payment of prizes, wages which for some workers greatly exceeds their presumed marginal products.When risk aversion is introduced, the prize salary structure no longer duplicates the allocation of resources induced by the optimal piece rate.For activities which have a high degree of inherent riskiness, payment based on relative position will dominate.Finally, when workers are allowed to be heterogeneous, an important result is obtained.Competitive contests which pay workers on the basis of their relative position will not, in general, sort workers in a way which yields an efficient allocation of resources.In particular, low quality workers will attempt to contaminate a firm comprised of high quality workers, even in the absence of production complimentarities.This suggests that high quality firms will use non-price techniques to allocate jobs to applicants.