Variable Pay and the Tournament Theory of Economics

Differentiation is something we talk about a lot. Yet there are subtleties that as a leader are very hard for me to wrap my brain around. On Differentiation Welch says:

“I just don’t like quotas in the boardroom or in the office.   Winning
companies are meritocracies.   They practice differentiation, making a
clear distinction between top, middle and bottom performers.   This
system is candid and fair, and it’s the most effective way for an
organization to field the best team.“ ““ Jack Welch, Winning, Pg 346

I tend to agree with that statement. Yet the word “meritocracies” even with the given Rand overtones leads us to believe people are paid fairly for the work they do. That just sounds right, doesn’t it? Pay people fairly for the work they do. ?

But economics suggests otherwise. Specifically the tournament theory of economics. In the Forbes article Why Your Boss is Overpaid Tim Harford explains:

The ugly truth is that your boss is probably overpaid–and it’s for
your benefit, not his. Why? It might be because he isn’t being paid for
the work he does but, rather, to inspire you. In other words, we work
our socks off in underpaying jobs in the hope that one day we’ll win
the rat race and become overpaid fat cats ourselves. Economists call
this “tournament theory.”

Or to have it explained by an economist, because that always clears things up, we have:

This explanation of wage differences in terms of relative performance is often called tournament theory. One place where this explanation should work is in contests with winners and losers. For example, consider two almost equally able gladiators fighting in the arena of ancient Rome. Small differences in ability (or luck) could result in a huge difference in reward–one could die and the other live.

Though gladiators are no longer part of our world, there are still cases in which winners matters a lot, and as a result, small differences in ability (or luck) can cause large differences in reward. The sports world has many examples.

Having started the company on 7k, for years I made sure I demonstrated the “boot strap” nature of business. I lived in a small house. Drove a civic. I am not of the personality to discuss my latest golf vacation to big sur (I don’t golf and I am not sure where big sur is, or if they have a golf course.) This works against me as a leader.

The theory goes that if you have a motivated employee. They believe in the company. They like what they are doing. And they look at the managers and the CEO and see them living below their means, driving sensible cars, that in fact this hurts the company. Good people will leave because they do not see the just rewards of the tournament.

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