Anja Schöttner and Veikko Thiele
We analyze the optimal combination of promotion tournaments and linear individual performance pay in an employment relationship. An agent’s effort is nonobservable and he has private information about his suitability for promotion. Thus, the two incentive schemes need to be combined to serve both incentive and selection purposes. If harder working agents respond less to intensified effort incentives, we find that the principal puts less emphasis on individual performance pay when selection becomes more important. Thus, we provide a possible explanation as to why, in practice, individual performance pay is less prevalent than promotion-based incentives.