Do tournaments solve the adverse selection problem?

• DOI: http://doi.org/10.1111/jems.12214
• Date: 01 September 2017
• Author: Theofanis Tsoulouhas
• Published date: 01 September 2017

Received: 29 September 2015 Revised: 22 December 2016 Accepted: 4 January 2017

DOI: 10.1111/jems.12214

ORIGINAL ARTICLE

Do tournaments solve the adverse selection problem?

Theofanis Tsoulouhas

Ernest & Julio Gallo Management Program,

School of Social Sciences, Humanities & Arts,

Universityof California, Merced, CA, USA

(Email: ftsoulouhas@ucmerced.edu)

Abstract

This paper provides a solution to a puzzle in the analysis of tournaments, that of why

there is no agent discrimination or differential contracting in certain business prac-

tice settings. The paper examines the problem of a principal contracting with mul-

tiple agents whose activities are subject to common shocks. The presence of com-

mon 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 there may be no need for ex ante screening through menus of offers. 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 uncer-

tainty 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 can eliminate it completely if agents are knownto 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

employees. The analysis connotes that by using relative instead of absolute perfor-

mance measures, firms with employees who are not substantially heterogeneous not

only can alleviate the agency problem, but there is also no need to extract the agents’

ex ante private information about their innate abilities via a screening menu.

1INTRODUCTION

It is well established in contract theory that under adverse selection the uninformed party can do better by offering a menu of

contract offers to the informed party than by offering a single contract.1Letting the agent self-select an offer from the menu

enables the screening of the agent’s type under appropriate incentive compatibility constraints. What is particularly puzzling is

the fact that in certain industries where the primary compensation mechanism is relative performance evaluation via a cardinal

tournament, uninformed parties offer a uniform tournament contract to all the agents. What explains this empirical deviation,

that is, the lack of agent discrimination at the time of contracting, from the anticipated theoretical optimum?

Considerable research on tournaments has been motivated by broiler contracting, ever since Knoeber (1989) identified the

importance of this application. Cardinal tournaments have been in use by processor companies during the production of broilers

(in houses owned and operated by growers) for decades now, and a lot of experience has been obtained with the optimal design

I am grateful to the participants of workshops at Concordia University,Montreal, University of California, Riverside, University of California, Irvine, University

of California, Merced, and Higher School of Economics, Moscow, and the participants of the Society for the Advancement of Economic Theory conference

at MINES ParisTech in France, the participants of the Conference on Research in Economic Theory and Econometrics in Milos, Greece, the participants of

ASSET in Aix-en-Provence, France, and the participants of the Western Economic Association International meetings in Honolulu, Hawaii, for very useful

comments.

J Econ Manage Strat. 2017;26:675–690. © 2017 WileyPeriodicals, Inc. 675wileyonlinelibrary.com/journal/jems

676 JOURNAL OF ECONOMICS & MANAGEMENTSTRATEGY

and fine-tuning of such incentive schemes.2One empirical regularity in the production of broilers, which is quite puzzling, is

the absence of agent discrimination at the time of initial contracting or at the time of subsequent recontracting, even after some

information about grower abilities has been obtained. It has been suggested that recontracting under more onerous terms once

some information about ability types is observed (i.e., the so-called “ratchet effect” ) can distort agent incentives to perform

initially, which can partially explain the absence of agent discrimination at the time of recontracting. However, the absence of

screening at the initial stage of contracting is extremely puzzling. Lack of agent discrimination can also frequently be observed

in the contracting of HMOs with physicians, in sales contracts and in determining annual raises for faculty.3

A cardinal tournament rewards an agent based on his performance relative to that of his peers, specifically, agents receive a

fixed base payment that induces participation, and a variable bonus which depends on the difference of an agent’s performance

from the average of his peer group. A cardinal tournament is a type of forcing contract that resolves the moral hazard problem

through penalties for performance below the agent group averageand rewards for performance abovet he group average.4Starting

with the seminal work of Lazear and Rosen (1981), Holmström (1982), Green and Stokey (1983), and Nalebuff and Stiglitz

(1983), ordinal tournaments (i.e., tournaments based on rank) and cardinal tournaments have been shown to alleviate the moral

hazard problem.5In addition to moral hazard on the agent side, cardinal tournaments, specifically, havebeen shown to alleviate

the moral hazard problem on the principal side as well.6However, do cardinal tournaments alleviate the adverse selection

problem? Lazear and Rosen (1981) argue that sorting between minor and major leagues would fail because agents would not

self-select (all agents would want to be in the major leagues, that is, in the high-ability group). Given that agents do not self-sort,

agents in the resulting mixed leagues do not exert the efficient effort. In this spirit, adverse selection due to agent heterogeneity

has not received enough attention in the tournament literature.7

If agents possess private information about their innate abilities at the time of contracting, the uninformed party, the principal,

can extract information by offering agents a screening menu and letting them self-select. Through the screening menu, the

principal can implement higher power incentives for higher-ability agents. This paper makes the point that, in the presence

of common shocks, relative performance evaluation enables the ex post sorting of agents which reduces the scope for ex ante

screening by costing less. Specifically,ex pos t relativeperformance evaluation contracts self-customize to agent abilities anyway

without ex ante self-selection or screening constraints, because agents receive a bonus if they exceed the average performance

and a penalty otherwise. An agent who beat the average subject to the same common shocks is more likely of higher ability.

Thus, if the principal can get information through ex post sorting at a lower cost, there may be no need to gain more information

through ex ante screening.

This paper provides a solution to the puzzle of no agent discrimination at the time of contracting (i.e., no differential con-

tract offers) which is traced to the very nature of tournaments (or relative performance evaluation) as opposed to the absolute

performance evaluation contracts that standard contract theory has considered. Specifically, tournaments screen and filter away

common production shocks from the responsibility of agents. Therefore, ex post relative performance of an agent is a measure

of an agent’s ability subject to his idiosyncratic (luck) component. By contrast, ex post absolute performance of an agent is a

measure of the agent’s ability, realized common production shocks and idiosyncratic shock. In other words, to the extent that

common shocks are relatively significant, ex post relative performance evaluation can improve the accuracy of inferences made

about agent ability. Thus, agents can be penalized or rewarded ex post according to their inferred innate ability. The ex post

ability to sort agents, by obtaining informative signals about their abilities, and discriminate reduces the scope for ex ante agent

discrimination (screening) via contract menus. By contrast, without tournaments, that is, with absolute performance evaluation,

high agent performance would be rewarded even if it were the sole outcome of pure stochastic effects that are common among

the agents. Thus, the contribution of the paper is to show that whereas ex ante agent discrimination through a screening contract

makes perfect sense with absolute performance evaluation and in accordance with standard contract theory (for instance, see

the analysis in Bolton & Dewatripont, 2005), no ex ante discrimination via a single pooling contract for each and every agent

can be optimal under relative performance evaluation via cardinal tournaments.8The analysis connotes an important policy

implication: by switching from absolute to relative performance contracts, firms employing agents who are not substantially

heterogeneous not only can alleviate the moral hazard problem, but they also do not need to worry about extracting the agents’

ex ante private information about their innate abilities.

The analysis characterizes an intuitive condition, which relies on a measure of agent heterogeneity, under which a pooling

contract offered to all the agents dominates the offer of a screening contract menu. Specifically, the analysis shows that ex post

sorting through relative performance evaluation can completely eliminate the scope for ex ante screening through menus if

agents types who accept a screening offer are not very heterogeneous. This is consistent with the stylized facts for the broiler

industry, at least, where growers (farmers) share similar attributes. Thus, in all, tournaments can solve the adverse selection

problem if agents are not very heterogeneous. This result is in sharp contrast with standard contract theory models without