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Prizes and Incentives: Towards a General Theory of Compensation and Competition

Barry J. Nalebuff and Joseph E. Stiglitz
The Bell Journal of Economics
Vol. 14, No. 1 (Spring, 1983), pp. 21-43
Published by: RAND Corporation
DOI: 10.2307/3003535
Stable URL: http://www.jstor.org/stable/3003535
Page Count: 23
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Prizes and Incentives: Towards a General Theory of Compensation and Competition
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Abstract

This article analyzes the role of competitive compensation schemes (in which pay depends on relative performance) in economies with imperfect information. These compensation schemes have desirable risk, incentive, and flexibility properties; they provide for an automatic adjustment of rewards and incentives in response to common changes in the environment. When environmental uncertainty is large, such schemes are shown to be preferable to individualistic reward structures; in the limit, as the number of contestants becomes large, expected utility may approach the first-best (perfect information) level. We study the design of contests, including the optimal use of prizes versus punishments and absolute versus relative performance standards. The analysis can also be viewed as a contribution to the multiagent, single-principal problem.

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