Your manager may earn a lot more than you, but it may not be because of the work he is doing or to keep him motivated. Instead, it is meant to motivate you and other potential successors. Some call this the worst argument ever for over-paid managers – but economists call this tournament theory.
Labour Economics journal founding editor Edward Lazear and the late Sherwin Rosen developed tournament theory in an influential 1979 paper. Lazear and Sherwin argue people are often promoted for being relatively “better” than their peers, not for just being good at their jobs. One reason this happens is because it is tough to calculate what earnings should really be, relative to performance: it can be much easier to simply say Jill is better than Jack.
Rafael Nadal is not really paid to play brilliant tennis; rather, he is paid for beating his rivals, such as Federer and Djokovic. He is paid, in a sense, to motivate every other player to go away and practise harder.
Anyone for tennis?
In sports tournaments, the effect of competition on player incomes can be easily seen. Tennis player Rafael Nadal is not really paid to play brilliant tennis; rather, he is paid for beating his rivals, such as Roger Federer and Novak Djokovic. He is paid, in a sense, to motivate every other player to go away and practise harder. Usually this strategy works: pay based on relative performance can be just as effective as earnings based on actual output.
UK economist Tim Harford in his book The Logic of Life: Uncovering the New Economics of Everything writes: "In most tennis tournaments, the winner of each match is guaranteed to make about twice what the loser does, and with a chance at further progress, too."
At Wimbledon in 2016, men’s and women’s singles winners could expect pay of £2 million each, while the 64 first-round losers in the singles competition got £30,000 each – a total £1.9 million. The winners earn more than all 64 first-round competitors put together.
Game on at work
What’s on the field can also reflect what happens in the office. Tournament theory can be integral yet invisible in office life, where employees are encouraged to compete and take risks. "The workplace tournament emerges from the fact that there is a limited fund for bonuses: the better you look relative to your peers, the less they will get and the more you will get. Or the tournament prize is a promotion to the next management tier,’’ writes Harford.
Tournament-based pay makes sense for employers as it allows them to keep their options open while promising to reward good work. Furthermore, it’s harder for employees to cheat when there’s no fixed level of achievement that will guarantee they “win” a reward.
Tournament theory can apply in many sectors, such as law firms where people often have to work very long hours and the pay gradient is very steep.
But tournament-based pay can be a double-edged sword. Behavioural economist Dan Ariely writes about peer effects in his book Predictably Irrational. He notes that man’s satisfaction with his salary “depends on whether he makes more than his wife’s sister’s husband”. Therefore, happiness at work often hinges on not knowing what colleagues earn.
Another downside is that tournament pay structures discourage co-operation. One study of Australian companies found workers in tournament-style pay structures were less likely to call in sick, but also less likely to share tools. People may also sabotage others’ work to make themselves look better, which partly explains why office politics is so rampant.