Promotion Tournaments and Individual Performance Pay

We analyze the optimal combination of promotion tournaments and individual performance pay in an employment relationship. An agents effort is non-observable and he has private information about his suitability for promotion. Thus, promo-tion tournaments and individual performance pay need to be combined to serve both incentive and selection purposes. We find that, if it is sufficiently important to promote the most suitable candidate, the principal provides incentives only bymeans of a promotion tournament. Thus, we give a possible explanation as to why, in practice, individual performance pay is less prevalent than promotion-based incentive systems.