Tournaments and contracts under asymmetric information

In a principal–agent model, we compare tournament and contract schemes, which are both common methods of inducing effort. We assume that an agent’s type, which was private prior to contracting, becomes public during a tournament due to players’ interactions. We show that first-best effort levels can always be achieved in an efficient tournament scheme (ETS), where each agent can upgrade the prize by paying a fee to the principal. Furthermore, we provide sufficient and necessary conditions for the ETS to generate a higher payoff for the principal than the optimal contract scheme (OCS), with examples under mild conditions. In the absence of performance shocks, we provide a rationale for using a combination of tournaments and contracts in the presence of asymmetric information.