Tournament Theory and its Relevance to Executive Pay

Essay, 2010

7 Pages, Grade: 2,0


Table of contents

1. Explaining the Issue of Tournament Theory

2. The Impact of the Tournament Theory on the Organization and its Employees

3. Conclusion

This assignment deals with the issue of tournament theory and will give an insight in its theoretical background and its relevance to executive pay. Moreover, the following pages will display the impacts of the tournament theory on organizations and its employees within a business context.

1. Explaining the Issue of Tournament Theory

The issue of Tournament Theory, which was first mentioned by Edward Lazear and Sherwin Rosen in 1981 (Shen, Gentry and Tosi 2010, 730; Norton 1994, 36), is related to a special CEO and executive compensation structure that rather focuses on a reward system than on absolute performance compensation to the subject. The reward system implies a prize that is awarded to that person, especially to executives (Shen, Gentry and Tosi 2005, 730), who performed as the best between his or her evaluated peer group becoming eventually the CEO or another top executive. Indeed, the prize is considered as the compensation at that position which comes normally along with astronomical paypackages (Anabtawi 2005, 30; Shen, Gentry and Tosi 2010, 730; Demsetz 1997, 114-115; Harford 2006). The person that wins the prize does it not because she came up with such a high productivity that is worth of a multimillion dollar payment - thus she does not win the prize in terms of its proportion to her absolute performance. Eventually, she will be assessed on how well she performed relative to her peers (Demsetz 1997, 114-115; Shen, Gentry and Tosi 2005, 730; Anabtawi 2005, 31; Norton 1994, 36; Harford 2006). The idea and application of the tournament theory and its compensation structure might be properly used when it is hard to observe and measure individual performance. In that case Shen, Gentry and Tosi (2010, 730) are stating that “it is efficient to pay individuals on the basis of organizational ranks, with more pay on higher levels, just like the prize scheme of a sports tournament.” Organizations use these tournament-scheme compensation structures because of high motivational aspects that are expected to come along with an enormous effort by employees from subordinated job levels (Anabtawi 2005, 30; Shen, Gentry and Tosi 2010, 730; Norton 1994, 36; Harford 2006). That means the greater the differentials among the boss`s compensation and the compensation of the job levels subordinated to him - and the more insane the boss’s pay and the less he has do to earn it - the bigger the motivation for the employees to work for moving up the corporate ladder (Milkowich, Newman and Gerhart 2010, 84; Harford 2006). In order to encourage and motivate employees and executives to exert substantial effort for being promoted to the next level the compensating structure is build upon high pay differentials between the top levels of an organization especially among the CEO and the next levels of the hierarchy (Anabtawi 2005, 38; Shen, Gentry and Tosi 2010, 730). When applying tournament compensation structures each executive will be faced with only two results to end up within the tournament - being promoted by getting everything and not being promoted by ending up with nothing even though the skills of that person are nearly the same and she had accomplished considerably results for the organization that person would not have been rewarded when another person had been achieved better results (Anabtawi 2005, 30). Straight forward to the phrase “Winner takes it all” (Norton 1994, 36). The individuals that have lost the tournament now are faced with a greater risk of losing in the tournament in later rounds since the likelihood of being promoted reduces. Individuals are getting older and the next round might be lasting several years of competing. Hence, the employees remain with fewer odds to compete in future rounds when peer executives become promoted. To offset this loss a substitute needs to be implied. Hence, the pay gaps in later rounds of the tournament come along with increasingly higher differentials to retain the incentives and avoid turnover of the executives. That is why there is often an enormous pay differential between the CEO and the next lower executives (Shen, Gentry and Tosi 2010, 730; Anabtawi 2005, 38-39; Norton 1994, 36). Furthermore if there were just a negligible pay increase between the CEO and the next lower level executives none of the lower executives would exert the effort to compete for and eventually execute the top position since the large accrual of obligation and responsibility at the top would never be worth for example just a hundred thousand dollars a year more (Norton 1994, 36). Moreover, according to Shen, Gentry and Tosi (2010, 730) the pay differential among the CEO and the next subordinate managers is actually requiring a much larger pay gap to motivate subordinate managers “to enter the final contest and compete for the top position”. Furthermore, it is necessary to compensate the CEO as he could not be rewarded anymore internally once he has reached the final top position.

2. The Impact of the Tournament Theory on the Organization and its Employees

As explained before a tournament compensation structure can have positive impacts on the organization and its employees as through large pay gaps between the top and the next lower levels executives might be highly motivated to compete for the top positions. That increases the productivity along the subordinate levels and thus the productivity within the organization. Moreover, tournament competition-based pay structures do have the benefit to provide lower information costs in terms of performance measurement. If an organization uses a pay-for-performance system it is necessary that there are any precisely measurable indicators of an employee’s performance. That is especially difficult when individuals are supposed to achieve results in a team cooperation environment where an individual’s effort is merely hard to measure. Given to the difficulty the organization will probably forced to expend high costs in order to obtain the required information for the evaluation of each individual. Anabtawi stated that “firms will be reluctant to motivate employees through pay schemes bases on absolute performance” (2005, 31). Indeed, they will rather concentrate on a tournament-based pay system where the performance measurement does not ask for accurately measurable indicators as the individuals will be judged based on a relative comparison to others. Thus, it will not be necessary to measure the performance of all employees or executives since the organization just have to choose a few executives that might be the most suitable to be promoted by judging and finally ranking them relative to each other (Anabtawi 2005, 31-32). Apparently tournament-based pay systems might have a positive impact on organizations itself in terms of less costly performance-monitoring and measurement systems.

Another positive impact that tournaments can imply is the aspect of inducing executives to make firm-specific human capital investments. In the case of a pay-for-performance compensation structure where the performance of individuals is difficult to monitor and measure and the individuals themselves are not able to verify their own absolute performance especially when they are supposed to work in teams organizations might tend to rate down the performance of the individuals at a lower level than it actually has been. Thus, they will be discouraged from making any firm-specific human capital investment as they perceive that they cannot use it anywhere else. However, tournaments can spur executives to invest in firm-specific human capital in order to compete and perform better in the contest and to obtain greater probability for being promoted when it comes to the relative performance ranking (Anabtawi 2005, 33-34).


Excerpt out of 7 pages


Tournament Theory and its Relevance to Executive Pay
Murdoch University  (Business School)
Managing Remuneration, Benefits & Motivation
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ISBN (eBook)
ISBN (Book)
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563 KB
Tournament Theory, Executive Pay
Quote paper
David Jamin Schneider (Author), 2010, Tournament Theory and its Relevance to Executive Pay, Munich, GRIN Verlag,


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