Promotion Tournaments and Individual Performance Pay

We analyze the optimal combination of promotion tournaments and individualperformance pay in an employment relationship. An agent's effort is non-observable and he has private information about his suitability for promotion. We find thatthe principal does not provide individual incentives if it is sufficiently important topromote the most suitable candidate. Thus, we give a possible explanation for whyindividual performance schemes are less often observed in practice than predictedby theory. Furthermore, optimally trading off incentive and selection issues causesa form of the Peter Principle: The less suitable agent has an inefficiently highprobability of promotion.