Why fat cats get fatter packages

| Updated on: Mar 30, 2016
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You’re talking about calorific excess among felines?

No, I’m talking executive compensation packages, since it’s that time of the year when the profit pie of companies is carved up and CEOs compensated for their strenuous exertions.

And are they doing well?

It’s still early days, but suffice it to say that they’re more than adequately compensated and won’t be moaning about the Krishi Kalyan cess. But that aside, I’m addressing a larger point.

Which is?

That if top dogs are making truckloads of money –– in some cases, seemingly disproportionate to their perceived exertions –– they’re really doing it for you.

Yeah, right!

No kidding. Infosys founder NR Narayana Murthy keeps banging away about the demerits of high CEO compensation packages and the need for “capitalism” to be “compassionate”. But, in fact, there is a tested economic theory that accounts for why top dogs rake in the moolah, while wage slaves toil away unrewarded. It’s called “tournament theory.”

Tell me about it…

The theory was postulated in 1981 by economists Edward P Lazear and Sherwin Rosen. They argued that as opposed to conventional performance-related pay structures at the workplace, where workers are paid a piece-rate (relative to their output), a system that converts the workplace into a “tournament” – where workers are rewarded for relative performance — is more efficient.

Their point: “the large salaries of executives may provide incentives for all individuals in the firm who, with hard labour, may win one of the… top positions.”

How does the theory work?

In a tournament, say at Wimbledon, players are compensated not for their performance in absolute terms, but for their relative performance vis-a-vis other players. Typically, the winner of each match is guaranteed to make about twice as much as the loser, and gets a chance to progress further in — and maybe win — the tournament.

As economic writer Tim Harford explains in The Logic of Life , turning offices into tournaments provides much the same incentive for a worker to perform better than one’s peers – and, ultimately, to occupy that corner office with a view.

How does that explain big pay packets?

As Harford points out, tournaments require “increasingly absurd pay packages” as workers go higher up the corporate hierarchy. That’s because at the lower levels, a promotion may be incentive enough, even if it is not accompanied by a pay increase – because it opens up the possibility of future promotions that pay lots more. But towards the end of your career, he argues, you don’t work hard just because it opens doors to the future. The incentive can only come from “a fat cheque.”

So, does a performance-linked-pay structure produce optimal results?

In most cases, yes. But it is possible to “game the system” and produce sub-optimal outcomes, as a sportsman in another field showed. In the late 1980s and the early 1990s, pole vaulter Sergei Bubka was offered a cash bonus every time he broke a world record. That incentivised him to beat his previous mark by the smallest possible measure rather than aim for his best jump. That way, he got many more bonuses.

The bottomline?

As Lazear noted in his book Personnel Economics for Managers , “The salary of the vice-president acts not so much as motivation for the vice-president as it does as motivation for the assistant vice-presidents.” So don’t fret that your boss is overpaid. He’s only trying to motivate you to get to where he is!

A weekly column that helps you ask the right questions

Published on March 10, 2018

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