The Cristiano Ronaldo effect on the Saudi Pro League

This past week, my ECONS102 class covered labour markets. Part of that topic is a discussion of superstar and tournament effects, which are explanations for why, within a particular labour market, some workers get paid a lot while most workers get paid very little. As an example, in the labour market for actors, the top actors get paid a lot, while the 'average' actor barely earns enough to get by (or doesn't earn enough to get by, which is why so many aspiring actors work as waitstaff at restaurants).

Superstar effects arise when the worker (the superstar) earns a lot of value for their employer. Labour markets with superstar effects generally have two features:

1. Scale – the top performers can satisfy the demand of a lot of consumers (which is more likely when the output is non-rival). That generates a very high value (technically, the value of the marginal product of labour, or VMPL) for the employer, with little additional cost; and
2. Non-substitutability – the particular job (or skills, or ‘style’) performed by the top performer is unique, and cannot be easily replicated by the ‘average’ worker.

Because of the high value created by the superstar, and non-substitutability, employers compete fiercely over these top performers, and so they will receive a very high wage. Movie stars provide a good example of the superstar effect in action.

In some labour markets, workers are rewarded for their relative (rather than absolute) performance. In these markets, workers essentially compete for a ‘prize’ – maybe a raise or a promotion, and they only need to be a little bit better than the second-best person in order to ‘win’ the prize. These labour markets are said to exhibit tournament effects. In these markets, the extra pay for the top workers arises not because they create more value for the employer, but as a way of incentivising workers to work hard (in order to try and 'win' the tournament). Good examples of tournament effects in action are the pay for CEOs, sports stars, or hedge fund managers.

How can we distinguish between superstar and tournament effects? Some markets actually have both, like the market for sports stars. However, for the high wages to be a superstar effect, the worker must generate much more value for the employer than alternative workers do. And that brings me to this recent article by Dominik Schreyer (WHU – Otto Beisheim School of Management) and Carl Singleton (University of Stirling), published in the journal Contemporary Economic Policy (open access).

Schreyer and Singleton look at the impact of Cristiano Ronaldo on the Saudi Pro League, after he was surprisingly signed by the Al Nassr club a few days after the 2022 FIFA World Cup. They note the potential for superstar effects here, specifically:

The Ronaldo signing, and subsequent player moves, could attract international tourists and foreign investments to the country, help market the TV product abroad...

Schreyer and Singleton look at the impact of Cristiano Ronaldo on stadium attendance, as a measure of his positive impact on the league. Their data comes from 240 matches played by 16 different clubs during the 2022–2023 season, noting that Ronaldo made his debut for Al Nassr on January 22 and played in 16 matches over the course of the rest of the season. In their preferred regression specification, Schreyer and Singleton find that:

...the estimated average effect of Ronaldo playing at home is 20% points of capacity, and the average effect of him playing away is 15% points, significantly different from zero at the 10% level (two‐sided test).

Moreover, when they look at whether there was a general impact of Ronaldo joining the league on attendance, they find that:

...the post‐Ronaldo‐playing period of the season 2022–2023 was associated with generally higher attendance demand across all matches, by 3% points of stadium capacity, significantly different from zero at the 10% level (two‐sided test), with a further significant 17% point effect when he played at Al‐Nassr's home.

Schreyer and Singleton conclude that this is evidence in favour of a superstar effect. However, I am not entirely convinced. How much additional value is Ronaldo generating for Al Nassr and the Saudi Pro League? Mean stadium capacity in Schreyer and Singleton's sample is just 26,000. So, an increase of 15-20 percentage points is an increase of 4000-5000 people in attendance at the game. That isn't going to generate anywhere near enough additional revenue to cover Ronaldo's salary of €180 million per year. Even with jersey sales and an increase in advertising or sponsorship revenue, this will not break even for Al Nassr. On the other hand, for Saudi Arabia generally this might be a good deal. Schreyer and Singleton note that:

The Ronaldo signing... [could] legitimize KSA's other foreign sports investments, including the 2021 takeover of Newcastle United FC...

Perhaps those broader benefits are worth more than Ronaldo's salary? Saudi Arabia may value the legitimisation quite highly (hence all the accusations of sportswashing). Still, it seems to me that at least part of Ronaldo's salary is a tournament effect. If Al Nassr had signed Kylian Mbappe instead, I'm sure they would have paid a hefty salary for the privilege. Instead, Mbappe is being paid the comparatively pauper-like salary of €36 million at Real Madrid. That suggests that the next best player earns far less than Ronaldo [*], which is indicative of Ronaldo's salary being a tournament effect.

*****

[*] We could argue endlessly about who are the top and second-best players. However, choose any from this list of the top-paid footballers, and the argument still holds up.

The benefits of the four-day workweek, in the presence or absence of tournament effects

The four-day workweek was in the news again last week. As reported in the New Zealand Herald:

An advocate of the reduced working week says it's time for New Zealanders to re-examine how they're doing business, and that cutting back hours can improve both productivity and mental health.

Charlotte Lockhart is the chief executive of the not-for-profit 4 Day Week Global project, which she established along with fellow New Zealander Andrew Barnes for like-minded people who are interested in the idea of a 32-hour working week.

She spoke with Sunday Morning about the need for change, and said that technology is making more flexibility possible in many workplaces.

"The reality is we know that the way we're going to work in the future isn't how we've worked in the past.

"There's no reason why we need to be working five days a week. It's not a mandatory number."

Lockhart is right that the five-day workweek is not a mandatory number, and neither is the 40-hour week. However, as I noted last month when I blogged about the four-day workweek in Iceland, there is a key point that advocates of the four-day workweek simply don't understand, and that is tournament effects. As I said in that earlier post:

...when there are tournament effects, people are paid a 'prize' for their relative performance (that is, for winning the 'tournament'). The prize may take the form of a bonus, a raise, or a promotion. The point is that each worker only needs to be a little bit better than the second best worker in order to 'win' the tournament. Those incentives would work to undo the decrease in work hours, since if everyone else reduces their work hours from 40 to 32, a worker that keeps working 40 hours will increase their chances of winning the tournament. If you doubt that tournament effects are real, I recommend asking any serious academic how many hours they work each week (since tournament effects are rampant in academia). This is not consistent with the overall goal of the four-day workweek, which is to reduce work. All it would do in these occupations is shift more of the work to outside of the paid workweek.

In occupations that have strong tournament effects (like academia, as well as professional jobs like lawyers, accountants, finance, professional sportspeople, etc.), shifting to a four-day workweek wouldn't change the incentives for the workers. If you work a little bit more than your peers, then you are more likely to 'win' the tournament and get the promotion, the prestige, the bonus, or whatever other reward the tournament is leading to. If your peers choose to drop down to working four days a week, all the better for you. They'll soon realise the cost of their choice, when the rewards accrue more to those who ignored the four-day-a-week call (just as they currently accrue now to those who work excess hours).

However, not all occupations have strong tournament effects. In some jobs, the tournament effects don't depend on productivity as measured on a weekly basis, but depend on hourly productivity. In those jobs, the workers are reasonably interchangeable as well, so it doesn't matter so much who does the work. Reducing from five days to four days a week for the same pay isn't going to reduce these workers' chance of winning the tournament (and if it increases their hourly productivity, as four-day-workweek proponents claim, then it might increase the workers' chances of winning). Consider service workers, or hospitality workers, or manufacturing workers, or construction workers, or administrators. They aren't competing for productivity-based rewards, or if they are, those rewards depend on hourly productivity, not weekly productivity. A four-day workweek for the same pay is a clear win for these workers (although a five-day workweek with a limited number of hours per day might be even better).

In some jobs, the potential tournament effects are reduced to some degree because promotion or salary advancement or prestige is determined by something other than productivity, like tenure. For example, salary advancement for teachers or nurses is based on tenure. Teachers or nurses don't work extra hours to get ahead of their peers in the salary advancement tournament (however, promotion or prestige might still reward those who work more hours). Moving them to a four-day workweek may be beneficial for workers in these jobs, to the extent that the structure of rewards counters the tournament effects.

There are clearly many jobs where the four-day workweek may have positive effects, but only where the tournament effects are weak, or where they are neutered by the way that the tournament is structured. Unfortunately, those are the jobs that the four-day-week advocates are focused on, to the exclusion of jobs where tournament effects are strong and unavoidable. A one-size-fits-all approach to adopting the four-day workweek is likely to be problematic.

Read more:

• Perpetual Guardian, four-day workweeks and the Hawthorne effect
• Iceland and the four-day workweek

Iceland and the four-day workweek

Iceland has been in the news over the last couple of weeks for the success of a trial of a four-day workweek (see here and here, for example). As the BBC reported:

Trials of a four-day week in Iceland were an "overwhelming success" and led to many workers moving to shorter hours, researchers have said.

The trials, in which workers were paid the same amount for shorter hours, took place between 2015 and 2019.

Productivity remained the same or improved in the majority of workplaces, researchers said.

I took these reports at face value, while noting that my concerns about the Perpetual Guardian trial in New Zealand, especially in relation to the Hawthorne effect, remain valid. However, it appears that there has been some misreporting of what was actually trialled in Iceland. Anthony Veal (University of Technology Sydney) wrote in The Conversation today:

It almost seems too good to be true: a major trial in Iceland shows that cutting the standard five-day week to four days for the same pay needn’t cost employers a cent (or, to be accurate, a krona).

Unfortunately it is too good to be true.

While even highly reputable media outlets such as the BBC have reported on the “overwhelming success” of large-scale trials of a four-day week in Iceland from 2015 to 2019, that’s not actually the case.

The truth is less spectacular — interesting and important enough in its own right, but not quite living up to the media spin, including that these trials have led to the widespread adoption of a four-day work week in Iceland...

The media reports are based on a report co-published by Iceland’s Alda (Association for Democracy and Sustainability) and Britain’s Autonomy think tank about two trials involving Reykjavík City Council and the Icelandic government. The trials covered 66 workplaces and about 2,500 workers.

They did not involve a four-day work week. This is indicated by the report’s title – Going Public: Iceland’s journey to a shorter working week...

Read on to the third paragraph and you’ll learn the study “involved two large-scale trials of shorter working hours — in which workers moved from a 40-hour to a 35- or 36-hour week, without reduced pay”.

A four-day week trial would have involved reducing the working week by seven to eight hours. Instead the maximum reduction in these trials was just four hours. In 61 of the 66 workplaces it was one to three hours.

Extrapolating from the effect of a reduction of 1-3 hours (for the majority of employers in the trial) to a reduction of 8 hours may be a bit of a stretch. Veal also notes the potential for the Hawthorne effect - workers know that they are involved in a trial, and that researchers (and their employers) are watching them closely. It is only natural that they would work a little harder, and this would manifest in higher productivity.

It may be too early for this (from the BBC article):

The trials led unions to renegotiate working patterns, and now 86% of Iceland's workforce have either moved to shorter hours for the same pay, or will gain the right to, the researchers said.

At least though, we can watch with interest how a larger scale shift to shorter working hours affects productivity in Iceland. However, to understand that question we would need to agree on what we mean by productivity.

In general, labour productivity is the economic output per unit of labour input. In this case, it really matters how you measure labour input. If you measure it in terms of hours of labour, reducing the workweek for all workers might increase productivity, while at the same time reducing the total output of the economy. That arises simply because of diminishing marginal returns to labour. Each worker is progressively less productive each hour that they work than they were the hour before (maybe tiredness or boredom are factors here). So, removing the least productive hours from the workweek will raise average productivity, but would still mean that less work gets done in total.

However, if you measure labour input in terms of the number of workers (or equivalent full-time workers, even adjusting for the change in definition of 'full-time'), then labour productivity will decrease. Unless you genuinely believe that there is negative marginal product from the hours that are being cut, in which case the employers are irrational and should have cut hours long ago, without any need for government intervention (why would an employer pay a worker for hours that decrease their total output?).

There are other salient issues that I don't think have been adequately canvassed on this topic. For instance, in jobs where there are significant tournament effects, there might be no decrease in productivity measured per worker. That's because when there are tournament effects, people are paid a 'prize' for their relative performance (that is, for winning the 'tournament'). The prize may take the form of a bonus, a raise, or a promotion. The point is that each worker only needs to be a little bit better than the second best worker in order to 'win' the tournament. Those incentives would work to undo the decrease in work hours, since if everyone else reduces their work hours from 40 to 32, a worker that keeps working 40 hours will increase their chances of winning the tournament. If you doubt that tournament effects are real, I recommend asking any serious academic how many hours they work each week (since tournament effects are rampant in academia). This is not consistent with the overall goal of the four-day workweek, which is to reduce work. All it would do in these occupations is shift more of the work to outside of the paid workweek.

Also, the four-day workweek may be great for employees, but how will it affect self-employed workers? Or 'contractors', who are nominally self-employed but have little control over their work conditions. Or workers in the gig economy? Or interactive service workers (e.g. baristas), where the potential productivity gains (measured per hour worked) are likely to be close to zero? Will governments need to adjust the minimum wage (which is expressed in hourly terms, not weekly terms)? Does this reduce holiday entitlements (which are generally expressed as a number of weeks, but each week is now four days, not five)? That isn't to say that any of these issues is fatal for a four-day workweek proposal, only that they are things that any government will need to think about before such a proposal goes ahead.

Read more:

• Perpetual Guardian, four-day workweeks and the Hawthorne effect

The 90-day trial, retail employers, and incentives

My nephew just lost his job, working for a large national retailer. He was employed sometime in November, and let go in early January. I don't know all the details, but the circumstances did get me thinking. So, I'm going to put my nephew's case aside, and write about a more general situation in relation to employee trial periods, that occurred to me when thinking about his case.

Small retailers (19 or fewer employees) in New Zealand can use 90-day trials, as long as this is specified in the written employment agreement (larger employers can't use these trials). Retailers face a couple of problems in terms of staffing. First, they can't easily tell from among the many applicants for jobs, who will be the most productive employees and who will fit into the workplace culture. This is classic asymmetric information - job applicants know if they are hard workers, but potential employers do not. The job interview process is a way of screening applicants, but it is imperfect. So, the 90-day trial gives employers a second chance to observe their new hires at work and see how productive they are. Second, retailers require additional staff over the busy holiday period, stocking shelves and attending to customers, etc.

It seems to me that the 90-day trial gives small employers an incentive to use the rules to solve both problems. Let's say the employer needs three extra staff over the holidays, but they also know that they need one permanent employee. They hire four applicants. However, before they hire them, the employer has no idea which one of the four will be the most productive, or the best fit for the workplace (or whatever other criteria they may have). So, instead of deciding on one of the new hires to put on a permanent contract, they put them all on permanent contracts. Then, at the end of the trial period, they let three of them go (and they don't have to give reasons), keeping the 'best' one of the four. This is what economists refer to as a tournament. Now, here's the important bit: the employer doesn't tell the four new hires that they are competing for one job.

How does this solve the two problems, and are their better alternatives? It solves the second problem obviously, because there are four workers for the busy holiday period. It solves the first problem, because the four workers will reveal their productivity during the trial period, since they know they are on trial and they want to keep the job when the trial period ends. Since they don't know they are competing with the others for a single job, they have less incentive to work in competitive ways that are unhelpful (such as sabotaging the other new hires' work), than they would if they knew they were in a tournament.

What about a simpler alternative? What if they employer put all of the workers on fixed term contracts for the holiday period, and then told them that there is a chance to be hired permanently at the end? The new hires would still work hard, but the tournament might become more obvious to them, and as above that might result in unhelpful competition. Also, there might be an end-of-game problem. If the new hires know that their fixed term is about to expire, and they suspect that their prospects of getting the permanent job are low, then they have less incentive to work hard. If they are on a trial period and don't know about the tournament, then there is less likely to be an end-of-game problem.

Anyway, I thought this was interesting, and probably wasn't an anticipated effect of the 90-day trials. It would only work for retail, or for other jobs where there is a short-term (certainly, less than 90 days) period of high demand for labour, followed by a lower base level of demand through the rest of the year. Hospitality jobs in some tourist areas that have a single high season (or two) might also qualify. I don't think this is necessarily a negative impact of the law (for example, I wouldn't label it an 'unintended consequence', as I have for policies that have unintended negative effects such as this one). After all, it helps the employer to better identify the 'best' employee for the available permanent vacancy, and that's what the law was designed to do. It's just that retailers can be much more efficient in using the law than most employers, who could only hire a single applicant at a time and try them out.

Social media influencers and superstar effects

In my ECONS102 class, we talk about why earnings differ between different jobs. However, even within jobs that are ostensibly the same, workers may have different wages. Putting aside the gender wage gap and discrimination, two reasons for differences in wages are superstar effects and tournament effects.

Superstar effects, described by Sherwin Rosen in the 1980s [*], occur because top performers are paid (in part) based on the amount of value that they generate for their employer. If a top performer generates a lot of value, they will be paid more. This explains much of the rise in earnings over time for top sportspeople or entertainers - as television (and more recently internet) viewership has grown, the value generated by a top sportsperson or entertainer (in terms of the number of viewers they attract) has grown, and their salaries or earnings have grown as a result.

Tournament effects, described by Rosen and Ed Lazear in the 1980s, occur when people are paid a 'prize' for their relative performance (that is, for winning the 'tournament'). The prize may take the form of a bonus, a raise, or a promotion. The point is that each worker only needs to be a little bit better than the second best worker in order to 'win' the tournament.

These effects are nicely illustrated in the case of social media influencers, as described in this article in The Conversation by Natalya Saldanha (RMIT University):

As people consume less traditional media and spend more time on social platforms, advertisers are increasingly using these influencers to spruik their products. A mega-influencer like Kylie Jenner, with 139 million followers on Instagram, can reportedly charge more than US$1 million for a single promotional post...

So far most of the indications are that the new economics of influencer marketing are not too different to the old economics of marketing.

As in the acting, modelling or music industry, there’s a tiny A-list of superstar influencers making millions. Then there’s a somewhat larger B-list making a handsome living. But the vast bulk of influencers would be better off getting an ordinary job.

In 2018 a professor at the Offenburg University of Applied Sciences in Germany, Mathias Bärtl, published a statistical analysis of YouTube channels, uploads and views over a decade. His results showed that 85% of traffic went to just 3% of channels, and that 96.5% of YouTubers wouldn’t make enough money to reach the US federal poverty line (US$12,140, or about A$17,900).

There are elements of both superstar effects and tournament effects here. If an influencer promoting a product can increase sales, then it makes sense that they will be paid more if they have more followers. So, a superstar with millions of followers will be paid substantially more than one with just hundreds or thousands.

And, influencers are competing for a scarce advertising spend, where successful influencers will attract paid work from many willing advertisers. Being slightly better than the second best influencer is likely to result in a disproportionate number of advertising contracts, increasing their earnings by a lot (and 'winning' the tournament). In contrast, slightly less successful influencers could end up earning less than the poverty line. This probably plays out separately in 'markets' for influencers with a broad appeal, and those whose followers are in a particular niche that advertisers want to target. Interestingly, the tournament effects here are little different to the effects for drug dealers, as Steven Levitt and Stephen Dubner describe in the excellent book Freakonomics (also described in this LA Times article from 2005).

Being a social media influencer isn't going to be a path to riches for the majority of aspiring wannabe Kylie Jenners. The best advice might be to try and exploit a very particular niche audience that advertisers are seeking and one that is not already occupied by one (or many) successful influencers. However, most of these wannabes are going to need a day job.

*****

[*] This was not a new insight, as Alfred Marshall had made a similar point as early as 1875.

Noah Smith on capitalist lyrics in rap

Noah Smith wrote back in 2015:

The economics of rap lyrics would be an interesting subject for a pop econ book...

One interesting thing is how overwhelmingly capitalist this theme is. A number of (white) lefty humanities students I meet are quite enamored of rap, viewing it as a form of protest against the structural injustice of the capitalist system. But barely any of that has been popular for many years now. The overwhelming majority of the mainstream popular rap music from the last decade and a half has been about working hard, taking risks, reaping financial rewards, and enjoying a money-driven status-conscious consumerist lifestyle. In other words, a total and utter embrace of the capitalist dream. Of course, the successful business exploits of rappers themselves are now well-known; the capitalist dream goes way beyond music-making.

Modern rap also puts the lie to the idea, popular in right-wing media, that rap encourages a culture of poverty. That was true of gangsta rap - even if he amasses money and power, a gangster is expected to stay in his community and remain true to the lifestyle of the streets (much like the ideal of noble poverty in chivalric fiction). But modern capitalist rap is about hard work and risk-taking in the pursuit of prosperity - exactly the kind of values conservatives ostensibly want people to have. Ludacris, whose music O'Reilly has repeatedly failed to recognize for the satire that it is, even has a song advocating Randian selfishness...

I don't think I'm reading too much into these songs, either; rappers themselves are obviously acutely aware of the importance of good formal economic institutions.

The music industry, including rappers, is characterised by tournament effects. With tournament effects (which I have written about before in the context of CEOs and football players), a small group of highly successful people earn a lot, while many others accept low pay in exchange for the chance to become one of the highly successful few at some point in the future. We probably really on get to see or hear about the success stories, while the less successful fade into obscurity. And no economist would be surprised that the successful rappers are those that act like rational business owners trying to maximise their profits, which is what we expect from capitalists.

Still, I encourage you to read the whole of Noah's post. I'm not a fan of rap (rap rock like Hollywood Undead, on the other hand, is a different story). However, reading that blog post reminded me of the first verse of Forgot about Dre, and the silver Ferrari in the music video:

Capitalism writ large.

[HT: Marginal Revolution just this week, even though it was a 2015 Noah Smith post!]

CEO pay is not all about CEOs' performance, or company performance

While I was away overseas CEO pay was back in the news, mostly courtesy of the continuing fallout from Theo Spiering's $8.32 million salary-plus-benefits package announced back in September. In the New Zealand Herald, Helen Roberts (University of Otago) argues for greater transparency in CEO pay:

We are continually told seven figure sums are needed to retain top executives, without any substance or proof that it needs to be that high.

The reality is that it is the independent third-party remuneration advisers who set the expectations. Compensation consultants use median pay levels from the previous year to determine the median pay level for the current round of contracts; as pay levels increase the median pay level also goes up, driving all CEO pay levels up in that industry.

So the decisions are effectively being made based on the recommendations of only a few.

This becomes a never-ending cycle of artificially inflated salary packages, irrespective of company performance or any parity with pay for salaried workers- companies are effectively being held to ransom.

She then goes on to talk about how loosely CEO pay is related to actual company performance (read the whole article, it's interesting). However, there is a key point about CEO pay that is missed from Roberts's discussion, and also from arguments in favour of high CEO pay, such as this earlier article by Jim Rose, who focused more on superstar effects and essentially argues that if CEOs weren't earning their large salaries, they wouldn't keep their jobs.

That missing point is that the market for executives is a tournament (which I have written about earlier, also in the context of CEO pay). In tournaments the winner is not only paid for their own performance, but paid a high bonus as an incentive for those lower down (e.g. the next tier of executives, in the case of CEO pay) to work harder.

Tournament effects were first described by Sherwin Rosen and Ed Lazear in the early 1980s. In labour markets where there are significant tournament effects at play, workers are paid a 'prize' for their relative performance - maybe a raise or a promotion. The tournament 'winner' only needs to be a little bit better than the second best worker in order to 'win' the tournament, and claim the prize.

However, if winning the tournament is mostly about luck rather than good performance, then the prize needs to be very large in order to incentivise the workers to work hard to 'win' (otherwise, if the prize is small, why work hard if winning comes mostly down to luck?). The large role of luck in performance could be argued to be true of top executives (the tier below CEOs), where their performance can only be measured by metrics that they probably have only small positive influence over (and are more driven by economy-wide factors, especially in the case of large companies). [*] So, because companies want to incentivise their (non-CEO) top executives to work hard, ensuring that the CEO pay is a large step up is one way to do so. [**]

So, the focus on the lack of clear relationship between CEO pay and company performance, and calls for increasing transparency of CEO pay setting, are at least a little misplaced. Unless we first disentangle the incentive effects that are directed at other top executives.

*****

[*] I say positive influence here, because I'm sure that a really bad executive can have considerable negative influence on a company's performance, but it isn't at all clear to me that for a broad range of competent executives, there is much to choose between them.

[**] I do wonder how vulnerable this theory is to the extent of internal vs. external appointments as CEO, since it seems to rely on internal appointments being the norm. On the other hand, the threat of external appointments could increase the incentive effects for internal top executives, since they would have to compete on performance with potential hires from outside the company.

Read more:

• CEO pay and tournament effects

Footballer earnings, superstar and tournament effects

In ECON110, we talk about the reasons that not all workers in the same labour market receive the same wage. In the 1980s, Sherwin Rosen identified 'superstar effects', where if a worker can satisfy the demand from many consumers, they get paid a higher wage. Essentially, the worker is rewarded for generating high revenues for their employer, as you would expect. This explains much of the rise in salaries over time for top sportspeople - as television (and more recently internet) viewership has grown, the value generated by a top sportsperson (in terms of the number of viewers they attract) has grown, and their salaries have grown as a result.

Rosen, along with Ed Lazear, also described 'tournament effects'. With tournament effects, people are paid a 'prize' for their relative performance (that is, for winning the 'tournament'). The prize may take the form of a bonus, a raise, or a promotion. The point is that each worker only needs to be a little bit better than the second best worker in order to 'win' the tournament.

As an example of tournament effects, consider a team of 20 players, who are all roughly equally talented but can be ranked from 1st to 20th in terms of their ability to attract consumers to buy products that they have endorsed. Let's assume that each player can endorse no more than two products (due to time constraints). Now say that there are 20 firms willing to pay the players to endorse their products, and we can rank the companies by their willingness-to-pay. The firm with the highest willingness-to-pay is willing to pay $20 million, and the second $19 million, the third $18 million, and so on down to the last firm which is willing to pay just $1 million. What happens?

The top player receives endorsements of $39 million (from the two firms willing to pay the most), the second player receives $35 million (from the third and fourth firms), the third player receives $31 million (from the fifth and sixth firms), and so on. The table below shows player earnings for all 20 players (ranked from 1st to 20th). Notice that the top earning players earn a lot, but half of the players earn nothing. This arises even though the players are all roughly equally talented, and leads to a highly skewed earnings distribution.

Obviously the example above is totally made up and very simplistic, but it's not so far from what we observe in the real world. Consider the earnings of top footballers. Even if we consider only the top ten players (by earnings, according to Forbes' 2016 list), this is what we see:

It would be difficult to argue that Ronaldo or Messi generate more than twice as much value as the others on this list, so the difference must be generated by something other than just superstar effects; that is, tournament effects. That is, when we look at players at a similar level of play, the difference in earnings is mostly tournament effects. In contrast, the difference in average salaries in England between Premier League footballers (£1.7 million) and League Two footballers (£40,350) is likely to be a mix of superstar effects (Premier League footballers generate more value for their employers than League Two footballers) and tournament effects (there's a limited number of places for Premier League footballers, so slightly worse players end up in lower divisions paying less).

One last point: It's been argued (I saw this argument first in Tim Harford's book The Logic of Life) that the size of the 'prize' for a tournament will be larger the more luck is involved. That is, if the difference between the tournament 'winner' and the others is mostly luck, the size of the bonus for working hard to win the tournament must be high in order to sufficiently incentivise the worker to work hard. So, if you buy that the difference in the graph above is mostly a tournament effect, does that mean that the earnings difference between Ronaldo and Messi at the top, and Neymar in third, is mostly down to luck?

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:

• When is an academic like a drug dealer?
• Are university vice-chancellors' pay increases justified?

Are university vice-chancellors' pay increases justified?

In the UK, the pay of university vice-chancellors' (VCs, the equivalent to president of a U.S. college) has been in the news recently. For instance, from Times Higher Education:

University vice-chancellors were paid £260,000 on average in the last academic year, a pay survey by the University and College Union shows

Neil Gorman, who was then vice-chancellor at Nottingham Trent University, earned the most in 2013-14 with his total benefits amounting to £623,000...

Seven universities paid their vice-chancellor more than £400,000 in salaries, bonuses, other benefits and pension contributions, the union said...

Sally Hunt, the UCU’s general secretary, said that the “lack of transparency and accountability surrounding senior pay and perks [was] a national scandal”.

Do university vice-chancellors deserve their high pay though? Not according to research cited by The Guardian:

The research, by economist Ray Bachan, from Brighton Business School, also looked at the extent to which the pay awards of university leaders were related to university performance measures, to shed light on whether headline pay awards were justified. In particular, it analysed vice-chancellors’ success in increasing the number of students from comprehensive schools and low-participation districts, and their record in bringing in income such as grants for teaching and research and capital funding.

It found that, while some of the pay increase could be explained by improvements in these areas, a “significant proportion” of the rise in vice-chancellors’ pay bore no relation to performance. Bachan said: “significant proportion of the sizeable annual increases are not easily explainable in terms of university performance, and this raises some concern.”

The research suggests that the presence of other high-paid staff in an institution pushes up vice-chancellors’ pay. University remuneration Remuneration committees, which set pay rates, may also seek to set the salary at a level commensurate with comparable institutions, said the study, which was published this month in the Fiscal Studies journal.

Note that The Guardian's headline is "‘Eye-watering’ salary rises for university chiefs cannot be justified, says report". The journal article by Ray Bachan (University of Brighton) and Barry Reilly (University of Sussex) in Fiscal Studies is available here (I don't see an ungated version anywhere). The authors do say something similar to The Guardian headline in the abstract:

However, even after controlling for a rich array of observable and unobservable factors, there have been sizeable increases in real pay in recent years that cannot be readily explained.

Having read the paper though, The Guardian's headline and the authors' abstract are both overstating the problem. There is nothing in the journal article by Bachan and Reilly that suggests to me that the salary rises are unjustified. I would argue quite the opposite, in fact. The authors use institutional performance as a predictor of VC salary. All three measures of 'mission-based performance measures' had positive and statistically significant relationships with VC salary, as did one of the three 'financial-based performance measures'. Other than year fixed effects, the among of funding council grants received was the most statistically significant determinant of VC salaries. So, I don't think it's correct to say that the salary rises cannot be justified - they are actually linked to institutional performance.

Of course the model doesn't explain all of the increases in VC pay - it has an R-squared of nearly 0.7, so the model explains nearly 70 percent of the total variation in VC pay. That leaves some 30 percent unexplained. But for an econometric model, that is really rather good. You might argue that not being able to explain all of the variation in VC pay means that the salary rises are not justified by performance. However, the models are not complete - there may be performance-related variables not included in the model that are important and might explain some of the remaining variation in VC pay. Indeed, the authors note themselves that:

Modelling the relationship between CEO pay and performance in the public sector is not an easy task. Estimating the relationship between VC pay and performance is also fraught with difficulties given data constraints. Our results suggest that institutional performance, external benchmarks and internal pay structures or tournaments play an important role in the pay-determining process. Nevertheless, if more detailed data on internal university pay structures (such as the pay of professors or other highly-paid staff) are made accessible or if compatible performance data on other aspects of performance not covered in this research (such as teaching and research) become available, more fruitful insights into this pay–performance relationship may be gleaned.

One further point to note is that the authors find that the proportion of staff earning more than £70,000 has a large positive and statistically significant effect on VC pay. They attribute this to tournament effects, which we have just finished discussing in my ECON110 class.

With tournament effects, a small group of highly successful workers get paid high salaries (VCs in this case), while many others accept lower salaries in exchange for the chance to become one of the highly successful few in the future. The high salaries at the top need not be related to performance of those at the top - instead, high wages at the top incentivise those lower down (e.g. other top executives) to work hard in order to ‘win’ the tournament. So, high VC (and CEO) salaries may motivate pro-VCs (and deputy CEOs) and others further down the organisational ladder who aspire to reach the top. And if the salaries of those lower down the ladder are high, the VC pay would need to be even higher to create an effective incentive. Which is essentially what the authors found.

Of course, not all academics are motivated to become VCs. The academic tournament is somewhat different  than the tournament for academic administrators (and I've blogged on that earlier - see here).

So, are the recent increases in vice-chancellors' pay justified? The research doesn't really answer that normative question fully, but possibly yes - at least, the research shows that increases in pay are linked to increases in performance. As to whether the tournament effects are 'justified', I leave that up to you to decide.