Showing papers by "Barry Nalebuff published in 1983"

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

Abstract: This article analyzes the role of competitive compensation schemes (in which pay depends on relative performance) in economies and 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.

Information, Competition, and Markets

Abstract: One of the dominant characteristics of modern capitalist economies is the important role played by competition: not the peculiar static form of pure price competition embodied in the Arrow-Debreu model, but rather a dynamic competition, more akin to the kind of competition represented by sports contests and other races (including patent races). In recent years, there have been several attempts to explain why firms often base the pay of their workers and managers on relative performance. (See, for example, Edward Lazear and Sherwin Rosen, 1981.) Such compensation schemes become desirable when three conditions are satisfied: (a) The input (effort) of workers (managers) must not be directly observable, at least without cost. Thus firms must either expend resources to monitor inputs or devise reward structures in which compensation is a function of variables (such as output or profits) which are themselves functions of inputs but are less costly to observe. (b) The relationship between input and output must be stochastic, so that by observing output, one cannot perfectly infer what the input was. (c) Finally, the stochastic disturbances which affect the relationship between input and output of different firms must be correlated. By looking at the performance of one worker relative to that of others, one can make better inferences about his effort than one can make without using this information. Not only can competition provide a basis of comparison, which enables the design of reward structures that can simultaneously provide a high level of incentives with relatively low level risk; but compensation schemes based on relative performance have the further advantage of automatically adjusting incentives to changes in the economic environment. (We refer to this as "built-in flexibility.") In a first best world, with perfect information concerning the nature of the technology (but where it is still costly to monitor individuals' activities), the compensation scheme would vary from time to time as the environment changed. Such changes in the compensation scheme are costly to implement and the information required to do so is seldom available. When a task is easier, the individual's rewards for performing the task should be reduced. If pay is based on relative performance, although all individuals perform better (when they exert the same level of effort), their compensation is automatically adjusted. Thus, teachers frequently grade on the curve and a significant fraction of the pay of successful salesmen often consists of bonuses based on relative performance.