Relational Bonus Contracts versus Rank-Order Tournaments with Envious Workers

This paper shows that relative pay comparisons among coworkers may induce employers to implement discretionary bonus pay rather than tournaments even if worker performance is nonverifiable. In a repeated game between the firm and its workers, I explore the trade-off between the agency costs due to the firm's commitment problem and those due to envy among workers. When workers are purely selfish, the tournament outperforms independent bonus contracts, while the result is reversed for envious workers if the firm's commitment ability is sufficiently high. Moreover, bonus contracts may become superior more often as envy among workers gets more pronounced.