Tournaments with gaps

- We analyze a moral-hazard problem with two risk averse agents.
- Since performance is unverifiable a tournament is used as a credible incentive scheme.
- Standard tournament contracts specify only tournament prizes.
- We show how this standard tournament can be modified to reduce labor costs.
- Such reduction is possible under unlimited liability but not under limited liability.

A standard tournament contract specifies only tournament prizes. If agents' performance is measured on a cardinal scale, the principal can complement the tournament contract by a gap which defines the minimum distance by which the best performing agent must beat the second best to receive the winner prize. We analyze a tournament with two risk averse agents. Under unlimited liability, the principal strictly benefits from a gap by partially insuring the agents and thereby reducing labor costs. If the agents are protected by limited liability, the principal sticks to the standard tournament.