Download this Paper Open PDF in Browser

Are Tournaments Optimal Over Piece Rates Under Limited Liability for the Principal?

37 Pages Posted: 28 Sep 2006 Last revised: 5 Dec 2012

Kosmas Marinakis

National Research University Higher School of Economics

Theofanis Tsoulouhas

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

Date Written: August 6, 2012

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

JEL Classification: D82, D21

Suggested Citation

Marinakis, Kosmas and Tsoulouhas, Theofanis, Are Tournaments Optimal Over Piece Rates Under Limited Liability for the Principal? (August 6, 2012). International Journal of Industrial Organization, Forthcoming. Available at SSRN: https://ssrn.com/abstract=932627 or http://dx.doi.org/10.2139/ssrn.932627

Kosmas Marinakis

National Research University Higher School of Economics ( email )

Myasnitskaya street, 20
Moscow, Moscow 119017
Russia

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

Paper statistics

Downloads
107
Rank
213,991
Abstract Views
764