Sometimes contracts are designed in a “winner takes all” format. This is more commonly referred to as the tournament theory. Tournament theory first arose in labour economics literature (Lazear and Rosen 1981) and it is prevalent in management research, where it has been commonly employed to explain compensation structures (Leonard 1990; Main et al 1993; Eriksson 1999; Messersmith et al 2011). Tournament theory has since expanded to a wide range of other disciplines and its principles have been applied to the likes of lawyers (Price 2003) and drug dealers (Levitt and Dubner 2009).
The idea of a tournament is that firms induce effort from employees by effectively pooling some portion of wages from all the employees at one rank into wages at the next highest rank, giving each opportunity to win promotion to that rank (Connelly et al 2014). Tournaments are therefore conceptualised as contests that are designed to entice an optimal level of effort from several actors, each vying for a prize that will be awarded based on relative rank (i.e. performance) (Lazear 1999, Connelly et al 2014). The prize is optimal, when it maximises the productive output of the tournament including all participants (Lazear and Rosen 1981, Knoeber 1989, Knoeber and Thurman 1994, Connelly et al 2014).
According to Szymanski (2003), tournament theory has its roots in the seminal work of Tullock (1980), which explores “rent seeking” behaviour by “contestants” for
agents extracting a return as a factor of production that is not a directly connected to their productivity, but more a consequence of their control over resources as a result of regulations or other constraints (Downward et al 2009).
Tournament theory consists of two main components. Firstly, prizes (pay level of promotions) are fixed in advance and are independent of absolute performance (Lazear and Rosen 1981). So if a vacancy became available for the position of CEO11 and there were only two contenders for this vacancy, it would not matter how much of a better candidate the eventual winner was, all that matters is that the winner was a better candidate. Secondly the prizes will not be awarded because the eventual winner has been better over a specific period of time, but will be awarded instead because the winner was better at that particular moment in time. In other words, absolute performance is irrelevant but rather relative performance is what matters (Lazear and Rosen 1981; Lazear 1998).
Tournament theory maintains that relative rank order prizes are superior to pay for performance compensation mechanisms, because they motivate a broader base of employees striving for promotion, rather than focus on a single individual. In competitive industries where firms may require a small group of “specialists” to perform specific duties and to provide a solid foundation on which the firm can be built around, tournament theory suggests the preferred choice to guide recruitment. Instead of the steady upward progress in the relationship between salary and experience which is present in other labour market theory (represented in figure 2.n above), tournament theory is perceived to contain “big jumps” where the “jumps” have represented a promotion and the “big” represents a “prize” (boost in salary) resulting from the promotion.
Tournament theory carries the assumption that there are distinct differences between the very best, the ‘winners’ and the next best, ‘the losers’ (Lazear 1998; Connelly et al 2014). The differences in core ability between the winners and losers may be worth a lot to employers and the argument of tournament theory is that these differences are rewarded substantially. A newly promoted CEO may have just acquired a big increase in salary and it could be argued that this role requires the largest pay rise as there is no more progression an individual can make within the company. It could also be argued
however that this salary is not designed to motivate the CEO and that the newly promoted individual’s performance is completely irrelevant, but rather this salary increase is intended to create competition amongst the several subordinates who were competing for this role when it was previously available.
Although tournament theory creates incentives (Lazear and Rosen 1981; Lazear 1998, 1999; Fredrickson et al 2010; Connelly et al 2014), there is a limit to the rewards a company can offer (Lazear 1998; 1999). The optimal level of incentive is attained as a result of trading off the value of additional effort against the compensation necessary to induce workers to supply that level of effort. In other words, it may be in some cases more useful or productive for firms to settle for a lower equilibrium effort level than to pay them lots more to raise effort only a proportionally small amount (Lazear 1998). At some point, it simply does not pay to induce greater effort levels from a firm’s point of view.
If prize spreads are too small, contestants will not have enough incentive to compete causing the total productive output of the tournament to drop. Similarly a prize spread too high can also be detrimental to tournament efficiency as it induces so much effort that contestants must be broadly compensated (Connelly et al 2014). Tournament design therefore involves strategically choosing optimal prize spreads that maximise productive output of the tournament. From an employer’s point of view the value of offering large spreads depends on the value of the extra output produced. Naturally, if the value of the additional output exceeds the value of the large spread in wage then it will be deemed worth it. However, even if large spreads fail to produce output of equal or greater value, the large spread may still need to be offered as employers are competing with each other in competitive labour markets. Therefore in labour markets where supply may be short, employers may be forced to offer large spreads (Lazear 1998).
In organisations that require some degree of team effort, managers may decide to compress the prize rewards. Conversely if the organisation believes that only a few members of the entire workforce are likely to produce the most value then managers may set these prize spreads far apart. Generally with tournament style pay systems, individuals are encouraged to compete for these prizes with the large spreads
As mentioned earlier in section 2.4.1 of this chapter, luck can occasionally play an important role in an individual’s productivity and performance and hence could also influence who ultimately wins a tournament (Lazear and Rosen 1981; Lazear 1991, 1998; Connelly et al 2014). Luck, good or bad can result from one of two main factors, production uncertainty and measurement error (Lazear 1991, 1998). Production uncertainty refers to when a worker has put in a lot of high effort into a task but their output has been low. This low level of output can on occasion be down to bad luck on the employee’s part as it could have been caused by an uncontrollable or unanticipated event. Luck however can also be positive, as on occasion a worker may be able to profit from the same unforeseen or unanticipated event.
Measurement error refers to when a worker may have been exerting high levels of effort but may have been unjustly or inappropriately ignored or perceived to have exerted medium effort. A superior may even then attribute high effort to another worker who has in fact produced very little. Both of these types of luck will reduce the value of effort as they reduce the probability of a worker being promoted. Ultimately, tournament pay styles are designed to reward workers for their level of effort, however if luck plays a prominent role in the decision of promotions then the link between effort and rewards will be broken, inevitably causing worker effort to decline.