Do Tournaments Solve the Adverse Selection Problem?

28 Pages Posted: 19 Oct 2013

See all articles by Theofanis Tsoulouhas

Theofanis Tsoulouhas

University of California-Merced, School of Social Sciences, Humanities & Arts, The Ernest & Julio Gallo Management Program

Multiple version iconThere are 3 versions of this paper

Date Written: October 16, 2013

Abstract

This paper provides a solution to a puzzle in the analysis of tournaments, that of why there is no agent discrimination in practice. The paper examines the problem of a principal contracting with multiple agents whose activities are subject to common shocks, when there is moral hazard and adverse selection. The presence of common shocks invites the use of relative performance evaluation to minimize the costs of moral hazard. But, in the additional presence of adverse selection, the analysis shows that at the optimum there may be no need for ex ante screening through menus of contract offers (i.e., for agent discrimination). This is so because the principal becomes better informed ex post about agent types, via the realization of common uncertainty, and can effectively penalize or reward the agents ex post. Thus, unlike the standard adverse selection problem without common uncertainty where the principal always benefits from ex ante screening, it is shown that ex post sorting through relative performance evaluation reduces the scope for ex ante screening through menus, and eliminates it completely if agents are known to not be very heterogeneous. This is consistent with observed practice in industries where the primary compensation mechanism is a cardinal tournament which is uniform among agents.

Keywords: Tournaments, Contests

JEL Classification: D82, D86

Suggested Citation

Tsoulouhas, Theofanis, Do Tournaments Solve the Adverse Selection Problem? (October 16, 2013). Available at SSRN: https://ssrn.com/abstract=2341925 or http://dx.doi.org/10.2139/ssrn.2341925

Theofanis Tsoulouhas (Contact Author)

University of California-Merced, School of Social Sciences, Humanities & Arts, The Ernest & Julio Gallo Management Program ( email )

Merced, CA 95343
United States
209-228-4640 (Phone)

HOME PAGE: http://tsoulouhas.info

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