Tournament Madness

OK, economists keep telling me that tournaments are inefficient, and I think they may be right, but I can't seem to get one to give me a cogent argument. So I asked my buddy Captain Imperio. CImP, as I call him, doesn't know anything about econ or tournaments, but he does know how to use the interwebs, so this is what he came up with:

People love tournaments. Economists, not so much. Why not?

Consider a certain idealized economic activity, widget manufacture, for example, and that widgets are an item in demand by a great many. By the nature of things, there will be a certain amount of variation in skill at widget manufacture, and the more skillful will crank out more widgets and make a better living than the less skillful. Net income for widget makers will be smooth function of skill, the less skillful will find other ways to make a living, and the number of widgets produced will tend ins invisible handy way to the number demanded by society.

Suppose, on the other hand, that the King desires a gidget. He only wants one, but he wants the best gidget possible, so he sponsors a month-long design contest and promises to pay handsomely (say $1 million) for the very best gidget available. Hundreds of citizens then begin designing and building gidgets in hopes of collecting the prize. At the end of the month, the King selects the winner, pays the designer, and everybody else goes home. This situation, says the economist, is bad, because hundreds of months were wasted designing and building gidgets that nobody wants.

What really really bothers the economist, though, is that this situation undermines the logic of the efficient market. The King was willing to pay big bucks because he really wanted a cool gidget. The gidget designers were willing to invest their time, because they calculated that their expectation of profit = probability of winning x amount of prize (say 1/500 x $1 million = $2000) was better than they could have made making widgets. However, if all concerned had been omniscient ideal market agents, the King would have just handed (say) some money to the one he omnisciently knew was the best gidget designer, gotten the design he wanted, and all the losing competitors would have saved their time and trouble – which looks like a Pareto improvement, that is, a change which makes nobody worse off and some better off.

If the only tournaments around were sporting events or occasional design competitions, this would be no big deal, but in fact tournaments are ubiquitous in the economy. All sorts of activities from hedge fund performance to job promotions to admission to the most desirable kindergarten are structured as tournaments. It is not implausible that the tournament structure of the financial industry contributed to the recent financial collapse.

Tournaments are a real challenge to market fundamentalists, because they suggest that there are situations (lots of them!) where rational actors with limited knowledge can make rational choices that wind up being bad for almost everyone.


Here is a more detailed discussion of the winner-take-all tournament

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