We analyze the optimal combination of promotion tournaments and individual performance pay in an employment relationship. An agent's effort is non-observable and he has private information about his suitability for promotion. We find that the principal does not provide individual incentives if it is sufficiently important to promote the most suitable candidate. Thus, we give a possible explanation for why individual performance schemes are less often observed in practice than predicted by theory. Furthermore, optimally trading off incentive and selection issues causes a form of the Peter Principle: The less suitable agent has an inefficiently high probability of promotion.
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Paper provided by Sonderforschungsbereich 649, Humboldt University, Berlin, Germany in its series SFB 649 Discussion Papers with number
SFB649DP2007-045.
Find related papers by JEL classification: D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law M52 - Business Administration and Business Economics; Marketing; Accounting - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects
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