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

Kosmas Marinakis and Theofanis Tsoulouhas

No 9, Working Paper Series from North Carolina State University, Department of Economics

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.

Keywords: piece rate contracts; tournaments; limited liability; bankruptcy; price uncertainty (search for similar items in EconPapers)
JEL-codes: D81 D82 (search for similar items in EconPapers)
Pages: 29 pages
Date: 2006-03, Revised 2006-09
New Economics Papers: this item is included in nep-ias
Note: First draft 2006-01
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Journal Article: Are tournaments optimal over piece rates under limited liability for the principal? (2013)
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