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Are Tournaments Optimal over Piece Rates under Limited Liability for the Principal?

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Author Info
Kosmas Marinakis () (Department of Economics, North Carolina State University)
Theofanis Tsoulouhas () (Department of Economics, North Carolina State University)

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Abstract

A highly acclaimed result in contract theory is that tournaments are superior to piece rate contracts when the agents are risk averse and their production activities are subject to a relatively large common shock. The reason is that tournaments allow the principal to trade insurance for lower income to the agents. Our analysis shows that this celebrated result does not carry over to the case when a limited liability constraint limits the payments the principal can make, provided that the liquidation value of the firm is sufficiently small. This finding has important implications for the vast number of limited liability firms. Tournaments are still optimal when the liquidation value of the firm is intermediate or large, even though the limited liability constraint is still binding for intermediate values. Surprisingly, uncertainty in the price of output strengthens the need for tournaments by expanding the range of liquidation values over which tournaments are optimal, because price uncertainty introduces additional bankruptcy risk.

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Publisher Info
Paper provided by North Carolina State University, Department of Economics in its series Working Paper Series with number 009.

Download reference. The following formats are available: HTML, plain text, BibTeX, RIS (EndNote), ReDIF
Length: 29 pages
Date of creation: Mar 2006
Date of revision: Sep 2006
Handle: RePEc:ncs:wpaper:009

Note: First draft 2006-01
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Related research
Keywords: piece rate contracts tournaments limited liability bankruptcy price uncertainty

Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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  3. Tsoulouhas, Theofanis, 1999. "Do tournaments solve the two-sided moral hazard problem?," Journal of Economic Behavior & Organization, Elsevier, vol. 40(3), pages 275-294, November. [Downloadable!] (restricted)
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    Other versions:
  5. Innes, Robert, 1993. "Debt, Futures and Options: Optimal Price-Linked Financial Contracts under Moral Hazard and Limited Liability," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 34(2), pages 271-95, May. [Downloadable!] (restricted)
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    Other versions:
  7. Tsoulouhas, Theofanis, 1996. "Labor and credit contracts with asymmetric information and bankruptcy," European Economic Review, Elsevier, vol. 40(8), pages 1665-1682, November. [Downloadable!] (restricted)
    Other versions:
  8. Andrei Shleifer, 1985. "A Theory of Yardstick Competition," RAND Journal of Economics, The RAND Corporation, vol. 16(3), pages 319-327, Autumn. [Downloadable!] (restricted)
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