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

Author

Listed:
  • Kosmas Marinakis

    (Department of Economics, North Carolina State University)

  • Theofanis Tsoulouhas

    (Department of Economics, North Carolina State University)

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.

Suggested Citation

  • Kosmas Marinakis & Theofanis Tsoulouhas, 2006. "Are Tournaments Optimal over Piece Rates under Limited Liability for the Principal?," Working Paper Series 009, North Carolina State University, Department of Economics, revised Sep 2006.
    • Handle: RePEc:ncs:wpaper:009
    Note: First draft 2006-01
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    File URL: ftp://ftp.ncsu.edu/pub/ncsu/economics/RePEc/pdf/TournamentsAndPieceRates.pdf
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    2. Theofanis Tsoulouhas, 2015. "A Primer On Cardinal Versus Ordinal Tournaments," Economic Inquiry, Western Economic Association International, vol. 53(2), pages 1224-1235, April.
    3. Dinopoulos, Elias & Heins, Gunnar & Tsoulouhas, Theofanis, 2024. "Effort, talent, and inequality in a small open economy," Journal of Economic Behavior & Organization, Elsevier, vol. 224(C), pages 248-265.
    4. Yaoyao Wu, 2022. "Disappointment aversion in tournaments," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 43(1), pages 26-30, January.
    5. Theofanis Tsoulouhas, 2017. "Do tournaments solve the adverse selection problem?," Journal of Economics & Management Strategy, Wiley Blackwell, vol. 26(3), pages 675-690, September.

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    Keywords

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    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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