Efficient tournaments within teams.

We analyze incentive problems in team and partnership structures where the only available information to condition a contract on is a partial and noisy ranking which specifies who comes first in efforts among the competing partners. This enables us to ensure both first-best efficient effort levels for all partners and the redistribution of output only among partners. Our efficiency result is obtained for a wide range of cost and production functions.

1. Introduction

* We study teams and partnerships in which risk-neutral partners jointly produce output which they share among themselves. It is generally accepted that such partnerships are inefficient if the partners' actions are not verifiable. The argument is that partners shirk because they must share their marginal benefit of effort with others but bear the cost alone. The question is, then, why are there well-publicized examples of extremely profitable partnerships which seem to have very little trouble providing incentives to partners?

We provide an intuitive answer to this question by focusing on team compensation schemes. These schemes are based on a partial and noisy ranking which specifies who comes first in efforts among the competing partners. We find that full efficiency can be obtained under the assumption that such a partial ranking of the partners' efforts is verifiable. This ranking should be less costly to acquire than cardinal information on efforts or a full ranking of efforts. Our result gives very clear recommendations on how to structure efficient bonus compensation schemes: nearly equal bonuses should be given to all members in teams where the information on the ranking of individual efforts is very precise, and a single, high bonus should be awarded in teams where effort monitoring is poor. In the motivating examples below, there are two main elements present on which we build our analysis: team output determines the pool from which prizes are taken, and information about relative performance is used as the means of allocating these prizes.

Partnerships are the dominant organizational form in several fields of the professional services industry, especially in law, accounting, and, until recently, investment banking. (1) The perceived advantages of partnerships are highly valued by dominant firms in these sectors. For instance, when Goldman Sachs was converted into a public company in 1999 it retained important elements of the partnership that it had maintained for 130 years previously. The $20.2 billion that Goldman Sachs set aside during 2007 for salaries and bonuses was roughly 50% of its net revenue (cnnmoney.com, 18 December 2007). As this pool is typically split into 40% salaries and 60% bonuses, this amounts to a bonus averaging $400,000 for each of its 30,000 staff. New partners are elected every two years. Because their share of this compensation pool is disproportionally larger than the associates' share, there is a fierce promotion tournament going on among the lower ranks.

Similarly, in the tradition of Galanter and Palay (1991), Rebitzer and Taylor (2007) argue that law "firms are typically structured as partnerships. Attorneys become partners via up-or-out promotion contests." Promotions are indeed lucrative, as "at Sullivan & Cromwell, for example, according to the American Lawyer, the average partner earned $2.35 million last year" while young lawyers at the same firm have to make do with a meager $145,000 (Wall Street Journal, 1 April 06). A performance evaluation system which could be used by a partnership for its promotion or bonus award decisions is the popular 360[degrees] assessment where subalterns, peers, and superiors of a given candidate are asked, typically on questionnaires, to assess the candidate. The partnership can use this noisy and at least partly qualitative information to decide on the ranking of partners, that is, on who to promote and who to fire. (2)

The model's most direct application is to partnerships in the professional services. However, because our setup is applicable to any partnership or team structure as long as there exist performance-related bonuses paid from the joint product, there is a much wider area of application in virtually any form of cooperation. As Battaglini (2006) observes, "Budget balance means that the mechanism cannot commit to 'throw away' surplus or to give it to someone who does not participate in production. Since budget balance can be interpreted as a constraint imposed by renegotiation-proofness, [our analysis] is relevant not only for those organizations in which budget balance seems a natural assumption from an institutional or empirical point of view (for example, a partnership), but for all the organizational forms."