Risk and Risk Aversion Effects in Contests with Contingent Payments

perc.tamu.edu 1 Contests and the influence of their design reach much further than just the sporting world. Firms seeking new products, investors backing competitors, and government agencies in search of design solutions are all examples of different models of contest design found in the marketplace. Those seeking new technology, innovation, design, and investment must select a winner from many participants. The participants expend resources to increase their chances of winning, knowing all the while that in the end, they may not be chosen. In the existing research on contests, it is commonly assumed that contest investments are paid up front by each contestant, regardless of whether the contestant wins the contest. In PERC’s working paper 1707, Risk and Risk Aversion Effects in Contests with Contingent Payments, authors Liqun Liu, Jack Meyer, Andrew J. Rettenmaier, and Thomas R. Saving analyze contests with contingent payment of costs where only the winner pays for the resources used in the contest. Contests by their very nature involve risk, winning and losing are both possible, and the gain from winning can, itself, be uncertain. The participants in a contest know that they can win or lose and use resources to better their chances of winning. Although many contest models exist, prior research has focused mainly on one type: where “the payment for the cost of these resources is paid up-front by the contestant. Using the symmetric Nash equilibria, previous research shows that risk-averse and prudent contestants choose to devote less resources to winning when the gain from winning is random, rather than certain. This group of contestants also devote less resources than risk-neutral contestants. The authors’ analysis here adds to these findings by comparing the equilibria reached by two groups of risk-averse and prudent (i.e., downside risk averse) contestants, with one group being both more risk averse and more downside risk averse than the other. In this paper, findings show that more risk aversion combined with more downside risk aversion implies a smaller equilibrium contest investment. Also, risk-averse and prudent contestants invest less when the prize is uncertain. The second model used, and the main focus of this paper, describes a contest where only the winning contestant pays for the cost of resources used in the competition. In this model, where the payment for the resources used to improve the chance of winning is contingent