Lazear, professor of human resources management and economics, believes that the subject of executive pay has been widely misunderstood. It should be examined in the context of the organization's hierarchy and assessed by how effectively it stimulates performance throughout the company. Lazear and economist Sherwin Rosen of the University of Chicago developed what they call the "tournament theory" of executive compensation, arguing that it is driven by the same logic that drives tennis and golf tournaments. Whether or not managers recognize this, it is implicit in the pay structure of any company in which a promotion involves a raise. Today that means most organizations.
How exactly does a corporation resemble a tennis tournament? To start, both typically offer rewards based on relative, as opposed to absolute, performance. In a tennis match, Chang needs only to play better than Sampras to take home the purse, and this motivates him to practice hard and play well.
This is true in corporate America, although less obviously so. While pay for "absolute performance" occurs (for instance, in the case of commission-based compensation for salespeople), pay for relative performance is more common and, Lazear argues, more effective in many situations. Like a winning tennis player, a junior executive isn't rewarded for performing well, but for outperforming his rivals.
What are the benefits of this system? If tennis players were rewarded for the quality of their game - on their absolute performance - their earnings would drop when it rains because it is hard to play well in the rain. But you can still beat someone in the rain - and if you are going to be rewarded for relative performance, the incentive structure remains intact, rain or shine. The same is true for executive vice presidents struggling in a weak economic climate or an industry slump. They may not be able to achieve magnificent returns, but maybe they can do a little better than a rival.
Linking pay to relative performance also eliminates unreasonable goals for performance. "If workers are expected to meet some standard, no matter how objectively it is set, occasionally the standard will be too high or too low," writes Lazear. "By judging individuals relative to one another, this extraneous element of arbitrariness is removed."
The second similarity between corporations and tournaments is that the bigger the purse involved, the harder people play. Think about a tennis match in which the winner takes $250,000, the loser $150,000. In your company that translates to Smith and Jones vying for promotion to senior vice president - and the $100,000 differential in salary. One hundred thousand dollars is a fair amount of money and a good reason to train hard and make sacrifices to win. "The amount of effort put in depends on the spread between the winner's prize and the loser's," says Lazear.
Not convinced? Consider evidence from another sport: golf. The Professional Golfers' Association found that raising total prize money by $100,000 lowered a player's score, on average, by 1.1 strokes over 72 holes.
By this reasoning, corporations should institute huge pay differentials to inspire maximum competition and performance. Lazear disagrees. Where the stakes are incredibly high and reward is based on relative position, Smith doesn't need to do outstanding work, he just needs to perform better than Jones. Smith can achieve this by working extremely hard, by making Jones look bad, or by a combination of the two. When salary differentials become too fabulously large, there is that much more incentive for employees to work harder - and also to sabotage each other. Think about yet another sport, figure skating, and the recent battle for the Olympic gold medal. Tonya Harding wanted the gold medal so badly she eventually wound up barred from competition. Sabotage may or may not help individuals flourish, but it is definitely unhealthy for an organization.
Lazear sees two ways around this. First, where cooperation is extremely important, there should be a somewhat compressed salary structure. There will be less incentive for hard work, but the payoff will come in the form of optimal cooperation. A company can also set up promotion structures so that people who need to cooperate have an incentive to do so - or at least no incentive not to. For instance, marketing managers and salespeople on the same account need to cooperate and share information. A shrewd manager will have them compete with people in different departments or different cities for the next promotion, not with each other.
But in order to do this, a manager must understand and accept the forces at work in the organization. Lazear says there has been some hostility to the application of economic principles to the field of incentives and executive compensation, long the domain of industrial psychologists. But whether or not managers like or even understand what he is saying, he thinks they run their companies according to the rules of the tournament theory. Says Lazear, "I don't argue that you should always motivate this way. But firms do it without even knowing they're doing it." When raises are given with a promotion, tournament rules and incentive structures are in effect. The managers who fully understand these rules and structures are the ones who will best be able to manipulate them to achieve higher profits.
"Rank-Order Tournaments as Optimum Labor Contracts," by Edward Lazear and Sherwin Rosen (Journal of Political Economy, October 1981)