Main, Brian G. M.; O’Reilly, Charles A. III; Wade, James
Abstract
Economists often explain the structure of pay among top executives in terms of “tournament theory,” in which the lure of a large prize for the winner motivates competition among many contestants. A CEO salary far above the individual’s marginal product might be economically efficient if it provides an incentive for other executives to work hard, at salaries below their marginal products, in the hopes of winning promotion. While tournament theory suggests that large salary differences among top executives may be efficient, an alternative theory suggests just the opposite. If the success of a corporation requires cooperation among its top management, then huge rewards for promotion may inspire excessive rivalry among individual executives; on this interpretation, a more compressed executive pay scale would be more efficient because it would promote teamwork. This article tests both theories empirically, finding support for tournament theory, but failing to demonstrate any efficiency gains from compression of executive pay differentials. The concluding comments suggest changes that are needed to make tournament theory more realistic.
