In a Belgian newspaper (September 14, 2019 - De Morgen), several people were second-guessing about why top executive pay has soared so high. Paul De Grauwe, professor in economy, asserts this dates back to the 1970s. However, this is what I wrote about it in the book (pp 693-694):
“Economists Lazear and Rosen (1981) developed tournament theory, basically contending that organizations should create rank-order tournaments, for example by paying high wages at the top of the organization. Thus, employees are viewed as competitors and are evaluated on the basis of relative performance rather than objective performance. Indeed, they wrote that if a vice-president rises to the rank of president (CEO), she or he could easily triple their salary even though this doesn’t mean that her or his skills have tripled also overnight. Rather, it is the prize they get for winning the contest.
In order to stimulate competition, they contended that firms should create wide pay gaps, even for small differences in actual contribution. In their opinion, this pay-gap would serve several purposes such as (1) avoiding shirking and (2) creating a sorting effect because ‘prizes’ would attract and retain the most talented workers, but also get rid of the ‘losers’ (it is predicted they will leave the organization).
The central propositions of their theory were that:
(1) pay-for-level-of-output is better than pay per hour because input-wage schemes without good effort monitoring often invite shirking;
(2) ‘competitive lotteries’ are sometimes even better: the people in the game are uncertain about how much they will earn, as the payment scheme follows a rank-order: the best performers get paid more (‘a prize’);
(3) large salaries for executives will provide incentives for employees who are willing to work hard to reach the ‘coveted top positions’—this is called the prize spread. It is predicted that each worker’s effort level will increase with the spread between the ‘winning and the losing’ prize;
(4) if the salaries of the other executives in the Top Management Team (TMT) are substantially lower than that of the president or CEO—e.g. 1/3 of the CEO salary—this will provide skill acquisition incentives for executives—this is called the vertical CEO-TMT pay gap;
(5) in general, the prize does not reflect current productivity, but past effort to perform well and to acquire the necessary skills during the time workers occupy more junior positions;
(6) people (‘players’) who are risk-averse will select themselves out, while risk-seeking people will select themselves in, even if only a few win large prizes. It seems the authors viewed this as a benefit.
To build their propositions, the authors based themselves on the Cournot-Nash assumptions that each player in a contest will try to optimize their personal benefit. The theory has been used to create all kinds of internal competitions and rank order effects, such as the forced ranking of employee appraisal scores.”