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

  • Kosmas Marinakis

    ()

    (Department of Economics, North Carolina State University)

  • Theofanis Tsoulouhas

    ()

    (Department of Economics, North Carolina State University)

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

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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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  19. Knoeber, Charles R, 1989. "A Real Game of Chicken: Contracts, Tournaments, and the Production of Broilers," Journal of Law, Economics and Organization, Oxford University Press, vol. 5(2), pages 271-92, Fall.
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  24. Theofanis Tsoulouhas & Charles R. Knoeber & Anup Agrawal, . "Contests to Become CEO: Incentives, Selection and Handicaps," Working Paper Series 002, North Carolina State University, Department of Economics, revised Jul 2004.
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