Rank-Order Tournaments as Optimum Labor Contracts

TLDR

When firms have heterogeneous workers, low‑quality employees may contaminate high‑quality firms, creating adverse selection. The paper investigates compensation schemes that pay employees based on their ordinal rank rather than output level. The authors analyze these rank‑based compensation schemes to assess their properties. For risk‑neutral workers, rank‑based wages produce the same efficient allocation as output‑based incentives; risk‑averse workers may also prefer rank pay, and when ability is known a competitive handicapping structure allows efficient competition.

Abstract

This paper analyzes compensation schemes which pay according to an individual's ordinal rank in an organization rather than his output level. When workers are risk neutral, it is shown that wages based upon rank induce the same efficient allocation of resources as an incentive reward scheme based on individual output levels. Under some circumstances, risk-averse workers actually prefer to be paid on the basis of rank. In addition, if workers are heterogeneous in ability, low-quality workers attempt to contaminate high-quality firms, resulting in adverse selection. However, if ability is known in advance, a competitive handicapping structure exists which allows all workers to compete efficiently in the same organization.