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Thats the title of a chapter in Tim Harford's book 'The Logic Of Life.

Its because executives play in a renumeration tournament. It is relative pay and bonuses that count as motivation. take a grand slam tennis tournament. The winner in the final gets MUCH more than the beaten finalist and MUCH more in turn than the beaten semi-finalists.

The point of having a huge renumeration deal for the CEO is not to motivate that person to work extra hard. It is to motivate the half-dozen or so people who might reasonably aspire to succeed that person to work extra hard. On this theory they need to be paid a lot less than the top honcho. And in turn this motivates the small crowd of people who might succeed them (and who in turn need to be relatively lowly paid). Thus the culture of unimaginable bonuses and options for the people who make it through to the 'finals' in the renumeration tournament.

The incentive system would work even if the CEO did nothing else than play golf - provided there is a small army of furiously over-achieving underlings trying to win the tournament by promotion to the next level.

Over in the USA Obama apparently intends to cap renumeration for top executives of organisations getting state help. This will wreak the tournament incentive structure. This could be interesting. It might be helpful to read up on tournament theory to understand some of the inevitable shrieks at this move.

Tournament theory has stood the test of time and has been supported by many subsequent pieces of empirical research. It also makes a perverse kind of sense: the more grotesque boss's pay, and the less he has to do to earn it, the bigger the motivation for you to work with the aim of being promoted to have what he has... so there you have it. Economists don't even pretend that your boss deserves his salary.

Tim Harford ' The Logic of LIfe: uncovering the new economics of everything' pp 106-110 in my UK edition

Harford has some interesting discussions on how tournaments arise in business - which suggest that the problems will not go away even if the system is subverted or taxed.

Tournament theory was devised by economist Ed Lazear back in the 1980's.

'Rank Order Tournaments as Optimum Labor Contracts' Journal of political Economy 89, No.5 (1981)

by saugatojas on Wed Feb 4th, 2009 at 11:06:10 AM EST

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