Monday, 15 June 2015

CEO pay and tournament effects

The New Zealand Herald released its annual executive pay survey results today. There was nothing surprising in the results:
The bosses of New Zealand's biggest companies enjoyed an average pay rise of 10 per cent last year, their biggest bump since 2010.
The increase for those at the top dwarfs the 3 per cent of growth for the average wage and salary earner in the year to June 2014.
So the folks at the top of the income distribution are earning more than ever, reflecting the recovery in business performance (on average at least). Of course, the pay increases and the differential in pay between the average worker and the top-paid CEOs have drawn sharp criticism as expected, not least for Theo Spierings (the CEO of Fonterra, in the news recently for its poor financial performance). However, what struck me was this commentary from Liam Damm, the Herald's business editor:
The NZX 50 index rose 18 per cent last year generating considerable wealth for shareholders including good returns for millions of KiwiSaver investors.
Chief executives typically have a large part of what they earn tied to performance targets. Last year most of those targets will have been met.
There will always be outrage from some quarters about the seemingly exponential scale of executive salaries. But we live in a free and global market where supply and demand set the pricing for talent.
Actually, that last bit is not true. The remuneration of chief executives is mostly NOT determined by supply and demand. It is determined by what are termed tournament effects. With tournament effects, a small group of highly successful workers (in this case CEOs) get paid high salaries, while many others (other executives, middle management, etc.) accept lower salaries in exchange for the chance to become one of the highly successful few at some point in the future.

The high salaries of CEOs need not even be related to their performance - instead, high wages at the top incentivise or motivate those lower down (e.g. other top executives) to work hard in order to ‘win’ the tournament. This explains why we might see CEO pay remaining relatively high even when the firm is performing poorly (like in the case of Fonterra - but to be fair, its poor performance isn't entirely down to its own doing, as I have pointed out here).

The pay of other executives and the size of the firm matter too. For instance, if the salaries of those lower down the ladder are high, the CEO pay would need to be even higher to create an effective incentive for the other top executives. And CEO pay would also need to be higher in larger organisations, where the chance of 'winning the tournament' is lower (because there are a larger number of managers competing).

So, high CEO pay is not determined by supply and demand but by tournament effects, which are also prevalent in other markets.

Previous posts on tournament effects:


  1. interesting read in the context of the above -

  2. Thanks for that - it does look like an interesting read. It has intuitive appeal too - that the rewards from innovation lead to greater social mobility and increased inequality.