Relative Performance Pay, Bonuses, and Job-Promotion Tournaments ∗

Empirical studies have challenged tournament theory by pointing out that (1) there is considerable pay variation within hierarchy lev-els, (2) promotion premiums only in part explain hierarchical wage differences, and (3) external recruitment is even observable on higher hierarchy levels. We explain these puzzles by combining tournaments with bonuses in a two-tier hierarchy. Under certain conditions the firm implements first-best effort on tier 2 although workers earn positive rents. Intuitively, the firm can use second-tier rents for creating incen-tives on tier 1. Furthermore, with unobserved worker heterogeneity, the firm improves the selection quality of a job-promotion tournament by including bonuses. Key Words: bonuses; job promotion; limited liability; tournaments JEL Classification: D82; D86; J33. ∗We would like to thank Oliver Gürtler, Jenny Kragl, Patrick Schmitz, and the partici