Tournament Rewards and Risk Taking

Abstract

I consider two seemingly unrelated puzzles. 1.Why is relative performance evaluation (RPE) used less in CEO compensation than agency theory suggests? 2.Why is sometimes, e.g., for fund managers, a 'modest' performance more highly rewarded than 'very high' performances? I consider a simple tournament model where agents can influence the spread of output in addition to its mean. I show that standard tournament rewards induce risky and lazy behavior from the agents. This finding sheds light on Puzzle 1. Second, I consider a scheme that ranks agents according to their relative closeness to a benchmark k. I show that there exists intermediate values of k such that the risky-lazy problem of the standard tournament can be mitigated, and first best level of effort can be implemented. This result sheds light on Puzzle 2.

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JEL Classification: C72, D29, G20, J41