Published on 11/15/2013.

The theme in my last two posts (minimum wages + Cristiano Ronaldo) was about Labor Economics, specifically about the discussion of wages, how they are constructed and determined. This post will culminate my posts on wages and conclude this series with a rather controversial issue, the wages paid to top executives. In this post, I'll discuss one of the possible explanations of this phenomenon, Tournament Theory which I believe does a good job in explaining this.

In my previous posts, I explained that the basic theoretical construction of how wages are determined. Basically, the worker can be paid an amount no more than the additional revenue he brings about for the company. That is if Joe, a factory worker, joins a company, and revenue increases by $100 – with no other associated expense – then he can be paid up to $100 by the management. Please see this post for a detailed explanation and examples.

When we talk about executives or managers and their compensation, it becomes rather difficult to assess their monetary contribution to revenue; after all they sit in an office not on the production line. I mean, how can you effectively value managerial skills? In the real world, we often hear about high executive pay relative to the average worker and high compensation packages. We want to know what the reasoning behind it is. An article by the Economist shows figures to highlight that. The figure below shows the ratio of executive pay to the average worker in several first world countries. You can clearly see the discrepancy and inequality in those numbers.

Let’s try and apply our previous analysis to the case of executives. Let’s say Jim is a vice president at a company, and he is paid $500,000 per year. In the traditional explanation I used, this indicates that Jim’s contribution to the revenue of the company is $500,000 or more. Let’s say overnight, Jim get’s promoted to be CEO, and his compensation rises to $2,000,000. It is rather ridiculous to argue that the value of Jim’s work rose four-fold overnight. His productivity (an essential determinant of wages in classical economic theory) was likely constant over this position change. So then why did he get paid a lot more when he became CEO?

In order to explain this phenomenon Economists Lazear and Rosen suggested the case of Tournament Theory in their 1981 paper. Instead of applying tournament theory to this discussion, I’ll explain it with the world of tennis (tournament theory is famously used to analyze sport competitions). My favorite tennis player is Roger Federer, he regularly competes in several tennis tournaments over the course of any season. Let’s take the case of the Wimbledon Tournament, the top prize of that Grand Slam reached 1.6 million GBP in 2013.

When Federer plays and wins, he progresses through the different stages of the tournament, and gets paid more and more for the next level of the tournament that he reaches. It is safe to assume that the higher award at each stage is to reward the player for reaching this point, and the progressiveness of the cash rewards serves to provide an incentive for players to move forward (the more you win, the more money you make). This ends until Federer wins the tournament, netting that 1.6 million GBP. He doesn't need to be the best in the world to win this tournament; he only needs to be a better player than all the other participants! This logic is applied in several knock-out tournaments in sports, such as the UEFA Champions League.

This idea can be applied to the discussion of executive compensation. The idea that the economists Rosen and Lazear suggested is that any company operates as a tournament, specifically speaking the progression of positions in the firm. Let’s explain this with an example. Let’s say Joe joins the company XYZ as an entry-level. He gets paid initially $50,000 per year. His direct supervisor gets paid $100,000 per year. Since Joe would like to get paid more money, this discrepancy in compensation provides him with an incentive to work harder and get the promotion, effectively increasing his compensation from $50,000 per year to $100,000 per year. After Joe gets promoted, his new supervisor gets paid $150,000 per year, again Joe has an incentive to work hard, get the promotion and start getting paid $150,000 per year. And so on so forth.

If you compare this to tennis tournaments, as Joe gets promoted, his compensation increases, thereby ‘rewarding’ him for surviving in the ‘tournament’ (working at the company basically). Thus every promotion Joe gets, the compensation increases. Naturally this can’t go on indefinitely, thus what is the highest prize? Of course it is the CEO executive pay, which is $2,000,000 for example. What happens when Joe reaches the CEO position? There are no more ‘stages in the tournament’? How can you convince Joe to stay at the company after winning the tournament? This theory suggests that high compensation at the CEO level is important to rewarding and keeping Joe after he won the tournament (became CEO).

Thus, the extremely high pay for managers just serves as incentive for workers to outperform themselves, learn and increase their productivity, in hope that one day they’ll be able to ‘win the tournament’ and become the CEO. If the idea didn't come across, see this article by Forbes which explains what I’m trying to illustrate.

Effectively, the high CEO compensation is for your benefit! I mean, all of us at some point want to get paid more and get promoted. Think about it for yourself; if you and your manager get paid the same amount, would you want to take his/her job? What if your manager earns double your salary (or three times, four times)? Would you want his/her job then? You’ll probably work harder for the promotion in the latter case.

In my view, the huge discrepancy in wages - especially in the US - cannot be explained by tournament theory. Increases in wage are reasonable at different levels of organizations, but they should be constructed to balance the positive effect of providing an incentive for workers to outperform and the negative incentive resulting from inequality within the organization. Additionally, huge discrepancies in wages at different levels could cause an unhealthy increase in competition between employees at the same level instead of having the right balance between competition and team work which is essential to the success of any organization.

In conclusion, similar to the discussion of minimum wages, tournament theory isn't the only explanation out there to explain the discrepancy between executive compensation and the wages of the average worker. This paper shows the empirical results of this analysis in the real world along with other different explanations to this phenomenon and it shows that tournament theory doesn't really work as it is intended to theoretically.