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.

So, according to the theory, it is not enough to differentiate your
people. That differentiation must be visible or in fact their is no
incentive to the others.

This also explains why your CEO talks about his thousand dollar car payment, brings up taking his car into the shop just to remind you he drives a Jag. Why he visibly takes time off to golf and jokes about it where you can hear. And why many pay packages are heavily laden with “performance pay” that is virtually unattainable. He does it for your benefit. And then asks you to come in on Saturday to catch up on work.

Office space basically is true. And why crack dealers live with their Mom because most of them can’t afford anything else!

For years I was not the highest paid person at the company. That is no longer the case. I finally got rid of the civic and purchased a Mercedes (don’t tell anyone but it was used). See, even now I feel compelled to justify a lower cost decision because that is how we built the company. We purchased at auction, we found creative ways to save and we sold like crazy.

So what to do with the young ones? The competitors have aggressive performance pay and hire two entry level people to “compete” for a more successful ones job. Is that the answer? As a leader I don’t like it and I know from experience that I was not a commission motivated employee at other jobs.

We have a system of profit sharing. Quite aggressive. But it does basically allow free loading. Certainly salary increases quickly differentiate the high performers from the low. But does in fact a balanced profit sharing program work at all? I just don’t know. Tournament theory says it likely doesn’t.

We have been having a content contest in the office. The idea is to encourage new helpful content that allows clients to help themselves. We all then receive higher profit sharing. Yet many in our wonderful company freeload. They benefit from others adding the content and don’t contribute.

Still thinking on this. Would love to hear your thoughts on tournament theory as well?