Obscene exec pay is not a prize

I normally like Tim Harford's analysis and conclusions about the frustrations of everyday life. However, this article in Forbes comes up short. Harford looks at the high level of executive pay and provokes us by suggesting that the pay is not for the exec's benefit but for the benefit of their underlings:

The ugly truth is that your boss is probably overpaid--and it's for your benefit, not his. Why? It might be because he isn't being paid for the work he does but, rather, to inspire you. In other words, we work our socks off in underpaying jobs in the hope that one day we'll win the rat race and become overpaid fat cats ourselves. Economists call this "tournament theory."

This an appealing theory for companies that have a policy of promotion from within. However, it does not apply to top level execs where many appointees are from outside companies.

Let's dissect the tournament argument. A company wants to motivate employees to outperform one another. They offer promotions with 'excessive' rewards. The rewards are greater than the person's immediate value to the company. However, seen as an incentive device they might make sense. So one could imagine that a company might commit to overpaying so as to save money motivating a mass of others; giving each a chance at a bigger prize.

But this all depends on the reward going to one of the contestants. If a CEO is an outside appointee that doesn't happen. In this case, the company is commiting to reward employees outside their own company. But they do not get the benefit from that (the higher productivity is elsehwere) so it does not make sense. [Of course, CEOs may be colluding but that is another matter].

Now you might argue that if there is a chance that an insider gets the job, then high exec pay expands the range of competition and may encourage more competition internally. But it also expands the field. So there is a trade-off. Competition can motivate but too many competitors can be de-motivating. Moreover, the CEO tournament doesn't run too often. So every time you actually appoint an outsider you are killing competition for awhile.