Sherwin Rosen

This paper analyzes compensation schemes which pay according to an individual's ordinal rank in an organization rather than his output level. When workers are risk neutral, it is shown that wages based upon rank induce the same efficient allocation of resources as an incentive reward scheme based on individual output levels. Under some circumstances, risk-averse workers actually prefer to be paid on the basis of rank. In addition, if workers are heterogeneous inability, low-quality workers attempt to contaminate high-quality firms, resulting in adverse selection. However, if ability is known in advance, a competitive handicapping structure exists which allows all workers to compete efficiently in the same organization.

It is sometimes suggested that compensation varies across individuals much more dramatically than would be expected by looking at variations in their marginal products. This paper argues that a compensation scheme based on an individual's relative position within the firm rather than his absolute level of output will, under certain circumstances, be the preferred and natural outcome of a competitive economy. Differences in the level of output between individuals may be quite small, yet optimal "prizes" are selected in a way that induces workers to allocate their effort and investment activities efficiently.