In a sport tournament, the rewards depend on relative performance not absolute performance. All the winner has to do is to beat the loser, no matter by how little. But the winner's prize money is a lot more than the loser's.
While the size of the prize money for the winner does not guarantee absolute performance in any one match, the absolute size of the prize money does raise the general absolute standard over time. The Professional Golfers' Association found that raising total prize money by $100,000 improved a player's score, on average, by 1.1 strokes over 72 holes. Specifically, the amount of effort put in depends on the spread between the winner's prize and the loser's. In other words, the greater the spread, the greater will be effort by every player. So the out-sized prize for the winner serves not much to reward the winner, but to spur on everybody who aspire to be the winner.
This tournament theory of reward has been applied to justify the high pay for the top executives in corporations. Specifically, the high pay is to motivate those who aspire to be the CEOs and not to reward the CEOs.
But there are some serious problems about this application. First, the spread between the CEOs and the next in line may not be set deliberately with the tournament effect in mind. Unlike top executive talents which are very scarce, the supply of vice presidents is a lot more plentiful. In effect, top executives and vice presidents are in two separate labor markets. It is this relatively scarcity that largely determines the pay spread between top executive and vice presidents. Second, even if the pay for top executives and vice presidents are set in tandem with a view to capture the tournament effect, it is unwise to do so. Management is not a sport tournament. In single-player sport tournament such as tennis and golf, the competitors are not in the same team. In a business firm, the CEOs and the employees are on the same team. Any outsized reward for the top executives would generate resentment among the rank and file employees. Employees at the bottom of the organization do not understand the sophisticated argument that the CEOs' pay is to induce better performance from his immediate subordinates. This resentment is more serious when bottom employees are asked to accept wage concessions while the top executives are given big incentives to stay onboard to revive a failing company. This absence of shared sacrifice between top management and rank and file employees has poisoned the morale of even successful corporations.
A more straightforward explanation for high top executives' pay may simply be the opportunity cost of top executives. In other words, a top executive's pay in one company must match the pay of top executives in other companies. Top executive talents are very scarce. Most of the pay represents demand-determined economic rent1. If some compensation boards2 that determine the executive's pay are too generous initially, other compensation boards simply have to match it in order to be competitive even though most pay packages have not been closely tied to executive performance.
Although the same labor supply might be forthcoming without the economic rent, the rent is often necessary to determine which employers would end up winning the service of the scarce talent. Getting rid of the economic rent thus amounts to imposing a price ceiling below the equilibrium market-clearing price.
- Economic rent is a payment made to a resource in excess of what is required to elicit its supply. The payment arises from current supply scarcity or legacy benefits that are difficult to do away with. It is needed to determine the employment but not the availability of that resource.
- Compensation committee is a subset of the board of directors. Members are supposedly non-executive (not employees of the company) board members who decide on the compensation for the top executives. Since board members are paid very well by the company, they may not want to offend the top executives who more or less appoint them. Additionally, the top executive of one company may serve on the compensation committee of another company and vice versa.
- Lazear, E. and S. Rosen. "Rank-Order Tournaments as Optimum Labor Contracts." Journal of Political Economy, October 1981.
- The Press (New Zealand). 10/23/2002. "Linking executive pay with performance."
- The Strait Times (Singapore). 5/28/2001. "It's $$$ if a CEO excels but the sack if he does not."
- Bebchuk, L. and J. M. Fried. Pay without Performance: The Unfulfilled Promise of Executive Compensation. Harvard University Press. 2004.