Standard models of promotion tournaments do not distinguish between wages and bonuses and thus cannot explain variation in the use of bonuses. We combine classic and market-based tournament theories to develop a model in which wages and bonuses serve distinctly different roles. We use this model to derive testable predictions which we test employing both a single firm dataset and a dataset encompassing a large segment of the Finnish economy. Our empirical analysis supports the testable predictions and shows that our theoretical approach better matches the data than alternative theories of bonus determination based on arguments already in the literature.
The Economic Journal.