Welfare effects of payment truncation in piece rate tournaments

This article analyzes the optimal response of a principal to the regulatory proposal which would truncate agents’ bonus payment in a piece rate tournament at zero. In a model with risk-neutral and heterogenous abilities agents, we analyze the principal’s problem of optimal choice of contract parameters under both regular and truncated tournament scenarios. The results show that the principal could significantly mitigate potential welfare losses due to tournament truncation by adjusting the payment scheme. The optimal adaptation to tournament truncation results in a situation where both higher and lower ability players would benefit from the policy while average ability players would lose.