Rank-Order Tournaments as Optimum Labor Contracts

It is sometimes suggested that compensation varies across individuals much more dramatically than would be expected by looking at variations in their marginal products. This paper argues that a compensation scheme based on an individual's relative position within the firm rather than his absolute level of output will, under certain circumstances, be the preferred and natural outcome of a competitive economy. Differences in the level of output between individuals may be quite small, yet optimal "prizes" are selected in a way that induces workers to allocate their effort and investment activities efficiently.