Last Friday, I was writing about zombie ideas in economics and finance that are still applied in the real world despite being proven not to work. You might have shrugged your shoulders back then, since you don’t care too much if your clients have suboptimal returns or your portfolio has a little bit more risk than it should have. But what if I told you that one of these zombie ideas may be responsible for you earning less than what you are worth and helps promote jerks to top management positions?
The idea I am talking about is tournament theory.
One of the challenges of businesses is how to compensate employees. It is pretty straight forward for some jobs where cause and effect are clearly linked. Take for instance car salesmen. Their job is to sell as many cars as possible. The person who sells cars worth twice as much as everyone else should make roughly twice as much money than everyone else.
But how do you compensate someone like me who produces research reports, especially if these reports are distributed for free? Or how do you compensate the mid-level manager who is in charge of a business unit but the success of this business unit not only depends on her and her team but the efforts of people from all over the company, ranging from marketing to legal to research and development etc.?
Ideally, you would compensate every employee of a firm according to the contribution he or she makes to the firm. But in practice this contribution is often hard to measure. In 1979, Edward Lazear and Sherwin Rosen showed that under certain assumptions the optimal allocation of resources (in this case salaries) can be achieved if employees are not compensated based on their output but on their relative position in the firm. Thus, the junior gets paid the least. The senior gets paid more, but less than his manager etc. until you end up at the top of the company where the CEO gets paid the most. What happens in such a company is that everyone looks at the person above in the company, realizes that this person makes more money and then is motivated to do more in order to get promoted and earn more money. In this idealized world, every employee advances to a level commensurate with his or her productivity and output and all is well. It is like a golf tournament or a tennis tournament where the best players end on top.
And since it is much easier to measure relative position in a company than actual output, tournament theory was quickly adopted, first in the US and later around the world and it is more or less stringently practiced in every major company today. After all, there are few bank tellers who make more than a senior research analyst and the salary of me and other research analysts is typically lower than the salary of a business head in a major bank.
Of course, the problem with tournament theory is that it is based on certain assumptions as I have said above. And these assumptions are typically not met in real life, which is conveniently forgotten by senior management who stands to benefit from implementing such a compensation model.
First, the theory assumes that employees are risk neutral, in the sense that they don’t care if they make more or less money. But we do care if we make more or less money! And if we do, then a more realistic assumption is to assume that employees are risk averse, i.e. they like jobs with a big upside but try to avoid the downside. In a world full of risk-averse employees, this relative compensation scheme still works if the job is inherently very risky with lots of upside and downside. In this case, the potential to make much more money than before can outweigh the risk of losing your job.
But in most jobs the upside in terms of salary, bonus or promotion is not very big compared to the downside of losing your job and your income. In these cases, compensation relative to your position in the firm is not going to motivate people to strive for higher productivity and output. Also, if employees feel that they have no chance of getting promoted to higher levels (for whatever reason) are likely to leave a company and go somewhere else where they see more upside. The end result is that in such a situation the low performers stay while the high performers leave.
Similarly, the theory assumes that each employee can be evaluated individually, but in today’s complex business world, the success of an individual is only possible while working in a team. If success depends on teamwork, then it is not just individual output that determines your fate in the company but how well you get along with other people. Et voilà, we enter the world of office politics. People who are better at politics and willing to exploit others to their own advantage suddenly can shine in such an environment and get promoted to positions of higher income. In other words, the systempromotes jerksin favor of productive people who are less willing or able to promote themselves or who are less able to play the game of office politics. In the long run, this can explain why there are a large number of jerks in top management positions even though many of them may not be well equipped to run the business.