This paper explores the optimal labor contracts in a competitive economy, focusing on rank-order tournaments as a form of compensation. The authors argue that compensation schemes based on an individual's relative position within the firm, rather than their absolute level of output, can be the preferred and natural outcome under certain conditions. They demonstrate that such tournaments can achieve the same resource allocation as piece rates when workers are risk-neutral, but differ when workers are risk-averse. The paper also discusses the implications of heterogeneous workers and the role of non-price techniques in allocating jobs. Key findings include: 1. **Rank-Order Tournaments and Piece Rates**: When workers are risk-neutral, rank-order tournaments and piece rates yield the same resource allocation. The choice between these schemes depends on the costs of assessing rank versus individual performance. 2. **Risk-Aversion**: When workers are risk-averse, the choice between tournaments and piece rates becomes more complex. Piece rates tend to dominate for distributions with low variance, while prizes dominate for high variance distributions. 3. **Heterogeneous Workers**: In the presence of heterogeneous workers, tournaments may not sort workers efficiently. Low-quality workers can contaminate high-quality firms, suggesting that high-quality firms may use non-price techniques to allocate jobs. 4. **Prize Structures**: The optimal prize structure for a tournament depends on the variance of individual outputs and the risk preferences of workers. For low variance, piece rates are more efficient; for high variance, prizes dominate. 5. **Adverse Selection**: In the presence of heterogeneous workers, tournaments naturally require credentials or other non-price signals to differentiate individuals and assign them to appropriate contests. This can lead to adverse selection, where workers prefer to work in firms with better workers, even without production complementarities. The paper provides a comprehensive analysis of the economic principles underlying rank-order tournaments and their implications for labor contracts and resource allocation.This paper explores the optimal labor contracts in a competitive economy, focusing on rank-order tournaments as a form of compensation. The authors argue that compensation schemes based on an individual's relative position within the firm, rather than their absolute level of output, can be the preferred and natural outcome under certain conditions. They demonstrate that such tournaments can achieve the same resource allocation as piece rates when workers are risk-neutral, but differ when workers are risk-averse. The paper also discusses the implications of heterogeneous workers and the role of non-price techniques in allocating jobs. Key findings include: 1. **Rank-Order Tournaments and Piece Rates**: When workers are risk-neutral, rank-order tournaments and piece rates yield the same resource allocation. The choice between these schemes depends on the costs of assessing rank versus individual performance. 2. **Risk-Aversion**: When workers are risk-averse, the choice between tournaments and piece rates becomes more complex. Piece rates tend to dominate for distributions with low variance, while prizes dominate for high variance distributions. 3. **Heterogeneous Workers**: In the presence of heterogeneous workers, tournaments may not sort workers efficiently. Low-quality workers can contaminate high-quality firms, suggesting that high-quality firms may use non-price techniques to allocate jobs. 4. **Prize Structures**: The optimal prize structure for a tournament depends on the variance of individual outputs and the risk preferences of workers. For low variance, piece rates are more efficient; for high variance, prizes dominate. 5. **Adverse Selection**: In the presence of heterogeneous workers, tournaments naturally require credentials or other non-price signals to differentiate individuals and assign them to appropriate contests. This can lead to adverse selection, where workers prefer to work in firms with better workers, even without production complementarities. The paper provides a comprehensive analysis of the economic principles underlying rank-order tournaments and their implications for labor contracts and resource allocation.