Tournament theory – the worst argument ever for overpaying executives

Overpaid

The executives in your company may be paid way more than they’re worth, but don’t worry – it’s for your own good.

That’s the point of a recent Forbes article defending overpaid executives which contains the single most disingenuous and illogical argument it has ever been my misfortune to see in a business context. From the article:

The ugly truth is that your boss is probably overpaid–and it’s for your benefit, not his. Why? It might be because he isn’t being paid for the work he does but, rather, to inspire you. In other words, we work our socks off in underpaying jobs in the hope that one day we’ll win the rat race and become overpaid fat cats ourselves. Economists call this “tournament theory.”


The article is based on a 25 year old economic paper on how tournament theory can be used to rank employees and allocate rewards like promotions and raises, arguing that:

  1. Performance is hard to quantify, therefore rewards like promotions and raises are decided more by luck than by qualifications or results
  2. Since rewards are mostly based on luck they need to be big or people won’t want to work hard to get them
  3. Overpaying executives motivates others to work hard because they can rise to the same position
  4. The tournament system is good for the company

I beg to differ. Here’s my step-by-step debunking to make sure we never have to see this horrible argument used to defend overpaid executives again.

1: Performance is hard to quantify, therefore rewards like promotions and raises are decided more by luck than by qualifications or results

From the article: …Managers find it hard to spot an excellent performance. It is a rare job where workers can be fairly paid according to some objective criteria.

This argument basically says that evaluating performance is tricky… so we shouldn’t even try to make salaries fair.

It’s clear to me that the most fair way to reward people at work is according to what they’re worth for the company based on their performance and results. This can be difficult to evaluate, but to simply give up and accept that rewards are mostly random seems silly and unfair. Even if we can’t find a system that’s 100% fair, we can try to make it as fair as possible.

2: Since rewards are mostly based on luck, they need to be big or people won’t want to work to get them

From the article: the more luck is involved in work, the larger the pay gaps should be between the winners and the losers. If Jack’s promotion is 90% luck and 10% effort, Jack may be inclined to goof off–unless, of course, the rewards for promotion are absolutely astronomical.

So: Promotions are mostly a matter of luck, and in order for this to work, the randomly awarded benefits have to be huge.

Am I the only one here thinking that it would make more sense to try to make rewards less dependent on luck rather than increase the rewards?

3: Overpaying executives motivates others to work hard because they can rise to the same position

OverpaidNo, this is fundamentally wrong. In fact, when rewards are the primary motivational factor most people become less efficient – especially when the rewards are unfairly decided. Alfie Kohn’s article on Myths About Money and Motivation is a great paper on this, based on massive psychological research.

Even if this kind of motivation did work, it could only work on those employees who have a reasonable shot at getting one of the overpaid jobs. But the majority of employees have long since accepted that they’re never going to be VPs or CEOs and for them the tournament system can only be demotivating because they see others getting unfairly large rewards that they will never get, no matter how well they perform.

4: The tournament system is good for the company

I think this system is little short of a disaster for businesses, resulting mostly in frustration among employees who are consistently not rewarded for doing great work. This frustration results in a loss of motivation and happiness at work and consequently to lower productivity and higher employee turnover and absenteeism, just to mention a few issues that can cost companies millions.

Also, a recent article in the New Yorker James Surowiecki points out that companies that overpay their CEOs have worse performance than others. One quote from the article:

One recent study of the market between 1992 and 2001 by economists at Rutgers and Penn State found that the more a C.E.O. was paid, relative to his peers, the more likely his company was to underperform in the stock market.

There are a few additional misconceptions in the article that need debunking.

Stock options

From the article: Tournaments also help protect workers against risks they cannot control. Companies can be affected by recessions, unexpected competition and hurricanes. As long as every worker is equally affected, the incentives to try hard remain the same. Trying to encourage performance through, say, stock options would unnecessarily expose workers to risks without really encouraging them to work harder.

First of all, I think it’s touching that companies want to protect their people by not giving them stock options.

At the same time, most CEO’s and other top executives do get stock options, because common wisdom dictates that this motivates them to better performance.

So in summation: Stock options for employees are dangerous and not really motivating. Stock options for executives are essential to motivate them. All clear?

The evidence

From the article: Lazear and Rozen’s tournament theory has stood the test of time and been supported by many subsequent pieces of empirical research.

There’s also massive amounts of research pointing out the opposite – I mentioned some examples above.

Suddenly everything is clear

From the article: Economists don’t even pretend that your boss deserves his salary. Suddenly, everything is clear.

But apparently some of them pretend that this is a good system, one that inspires employees to do their best at work and creates good performance in a company. Some of them even say that it’s good for the employees.

I find it more likely that these theories are floated in an attempt to make an unfair but ingrained business practice survive a little longer against the onslaughts of common sense. Like all such attempts it’s ultimately doomed to fail.

Did I miss any more fallacies in the original article? Tell me about them in a comment.

What to do instead

Alfie Kohn’s recommendation is simple: Pay people as fairly as you can. Then focus on other things than rewards.

True motivation and great performance at work is never about salary – very few people do their best work while wondering how much cash they will make from it.

The tournament argument completely fails to appreciate this and that’s why companies who choose this approach are forever doomed to sub-standard performance, massive frustration and zero motivation.

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10 thoughts on “Tournament theory – the worst argument ever for overpaying executives”

  1. I’m glad you talked about this topic (I know I pointed it out first, but as I told you before, I don’t agree with it ;).

    There are many “corporate wisdom” phrases that seem more like a justification to how thinks are done than a real explanation. Here’s the last one I heard from a guy that has been manager for 20 years: “people don’t work if you’re not constantly kicking their ass”.

    Of course, it seems “easier” to kick people’s ass than creating a culture when everyone ENJOY their job and consequently DO their job. It “seems” easier, but I think is not. To create a great environment you have to invest a lot of energy, change people’s mentality and create a commitment to happiness in the company, but then everything will go on smoothly. In the other case, you’ll have to “kick people’s ass” forever. Well… not forever. Just until they quit, or either the kicked or the kicker dies, whatever comes first :P.

  2. “Trying to encourage performance through, say, stock options would unnecessarily expose workers to risks without really encouraging them to work harder.”

    Huh? Does this guy understand stock options? There is no downside risk with stock options. The stock goes up, you exercise and win. The stock goes down, you don’t exercise.

    Now that I think about it though, maybe they mean it’s less risky to just pay employees a salary rather than give them options that may not be exercised. Ah well. Way to debunk this theory anyway.

  3. I agree Neil, this whole argument makes very little sense.

    The physicist Wolfgang Pauli once commented on a bad science paper that “This isn’t right. It’s not even wrong”. That’s how I feel about this entire argument :o)

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  5. you article does not defy the tournament theory, it just point out where you fail to understand the implications of the theory.

    For instance, the theory doesn’t say that chances of moving up in the company depend mostly on luck. It says that there is a force that prevents people from being promoted strictly on basis of their relative performance (to coworkers), and this force is the error term which we call “luck”, but you could also cal it static. It is a factor that prevents us from observing actual performance and effort by the worker, and it exists in nearly all companies.

    Furthermore, this theory wasn’t invented to push a salary scheme that greatly rewards CEOs, but this theory was merely trying to explain why in the real world, many companies have such a highly skewed salary/bonus distribution.

  6. Hi,

    9 years later, I have stumbled upon this article and do not agree with some of the points.

    You make some very good points but ones that I don’t think Economists would disagree with. Yes, companies would like to reduce the luck factor so that they don’t have to increase the pay spread as much, however, frequently this can be exogenous, in that it is predetermined for numerous reasons, perhaps the people deciding on the promotion has a biased towards one candidate.

    Furthermore, it is not to motivate those at the bottom of the ladder, but those who are near the top and have a chance of getting the job. I agree, and I’m sure others would that it can be dismotivating for workers to see the people running the company on extortiate fees but the people underneath them are working hard, and arguably harder than they would, to try and gain that salary.

    As you said, there is evidence that people don’t respond to money as an incentive but, this is mainly because those firms who have only pay incentivised staff lack a lot of non-monetary, fringe, benefits which is actually the demotivating part. In tournament theory, the hypothesis that a VP would prefer to work hard and become CEO for $1.5m instead of $500,000 seems to be pretty logical and evidence does support that they will work harder when the pay spread is higher.

    If you want to use empirical evidence against tournament theory, then it needs to disprove that higher pay spreads are unmotivating or, if you would rather prove it is a bad idea for companies, prove that it does not motivate the workers vying for a position to a higher benefit than the cost of the position. However, tournament theory is supported by empirical evidence. For golf tournaments, see Bognanno (1990), for evidence of increasing pay spreads see Main, O’Reilly, and Wade (1993), Eriksson (1999) for the role of luck on pay spreads and Audas, Barmby, and Treble (2004) for how larger pay spreads leads to reduced absenteeism as a means of higher effort.

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