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Tournament Theory and Compensation November 22, 2008

Posted by A Texan In Grad School in Economic Theories.
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Dan Ariely, author of Predictably Irrational, opines in the NY Times about bankers’ compensation.  He claims that, “for most bankers, a multimillion-dollar compensation package could easily be counterproductive.”  He cites some experiments he recently conducted in which high results-based compensation was correlated with poor performance on cognitive skills, but improved performance on mechanical skill.  Another experiment found that public scrutiny had the same effect (i.e. Scrutiny led to a desire to perform better, but an actually worse performance). I believe Ariely is engaging in some demagoguery.  Why else pick bankers as his target?

First, the banking sector is highly regulated and scrutinized by multiple authorities.  So unless bankers are suddenly given a great deal of secrecy for not only their practices, but also their results, changing their compensation won’t make much of a difference.  Now that we know banking is a high-pressure industry, we must ask: How do we find people that perform well under these circumstances?  One method is to offer high compensation to the top employees and executives.  This motivates people to try to join the firm in the lower-level positions with lower compensation because they are essentially in a tournament to win the top pay-rate.  This is well explained in Tim Harford’s The Logic of Life.

For comparison, consider professional athletes.  Now one may retort that Ariely’s research shows that mechanical performance is improved by the pressure factors (money and scrutiny).  But professional athletes do not sit and “…[tap] a key as fast as possible.”  Pro athletes are most definitely engaged in a cognitive task deciding when to pass, shot, block, pick, tackle, etc.  yet Ariely doesn’t question their compensation packages.  As one of my professors frequently points out: If you oppose pay levels to one group of people, then you have to oppose the same levels to all other people.

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