Tournament theory
Encyclopedia
Tournament theory is the theory in economics
used to describe certain situations where wage differences are based not on marginal productivity but instead based upon relative differences between the individuals. This theory was invented by economists Edward Lazear
and Sherwin Rosen
.
Good examples of the applicability of this theory are found in professional sports or the practice of law. Tournament theory also appears in writing - one writer may be fractionally better at writing than another (and therefore have a better book), but because people allocate (have) small amounts of time to reading, the writer with the marginally better book will sell far more copies as people only want the one book.
The paper invites the reader to consider the lifetime output of a worker at a firm. This output is dictated by two things - chance and skill. The worker can control his lifetime output by investing in skills early on in life,like studying hard at school and getting good qualifications, but a part of that output will be determined by chance. Partakers in the tournament commit their investment early on in life and are unlikely to know each other previously, within the firm they work in, and may not even know each other within the firm. This prevent collusion or cheating in the tournament.
Looking at the tournament in its simplest form, a two player tournament, where there is a prize for the winner and a smaller consolidation for the loser. The incentive to win increases as the difference between the losing and winning prize increases, and therefore the investment of the worker is increased as the difference between the winning and losing prizes is increased. It is in the interest in the firm to increase the spread of prizes. However there is a drawback for the firms. As the workers invest more their costs rise. Competing firms could offer a tournament with a lower spread and attract more workers because they would have to invest less. Therefore there is an optimal prize spread that firms set, high enough to induce investment but low enough so that the investment is not too expensive for the worker. The prize may take the form of extra cash or a promotion - which means more money, as well as entering a higher level of tournament, where the stakes may be higher.
The idea that the prize may be in the form of a promotion explains why presidents are paid significantly more than vice presidents. In one day a Vice-President may be promoted to President of a company and have his pay trebled. Considering piece rates this seems illogical - his output is unlikely to have tripled in one day. But looking at it using tournament theory it seems logical - he has won the tournament and received his prize - presidency.
Tournament theory is an efficient way of labour compensation when quantifying output is difficult or expensive, but ranking workers is easy. It is also effective as it provides goals for workers and incentivises hard work so that they may one day attain one of the coveted positions at the top.
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...
used to describe certain situations where wage differences are based not on marginal productivity but instead based upon relative differences between the individuals. This theory was invented by economists Edward Lazear
Edward Lazear
Edward Paul "Ed" Lazear is an award-winning American economist, considered the founder of personnel economics, and was the chief economic advisor to President George W. Bush.-Career:...
and Sherwin Rosen
Sherwin Rosen
Sherwin Rosen was an American labor economist. He had ties with many American universities and academic institutions including the University of Chicago, the University of Rochester, Stanford University and its Hoover Institution. At the time of his death, Rosen was Edwin A. and Betty L...
.
Good examples of the applicability of this theory are found in professional sports or the practice of law. Tournament theory also appears in writing - one writer may be fractionally better at writing than another (and therefore have a better book), but because people allocate (have) small amounts of time to reading, the writer with the marginally better book will sell far more copies as people only want the one book.
Corporate Structure
When selecting an employee for promotion, the employer will have a pool of candidates who are all able for the, job but only one, who is a fraction ahead of the rest, enjoys the fruits of the promotion – a potentially substantial increase in pay for only being fractionally better than his peers. Another drawback to promoting people based on their relative performance is that it may lead peers to sabotage others work instead of excelling themselves. However there are many benefits of using tournaments to allocate wages and promotions. Firstly, it is easier to merely rank workers than to quantify their efforts, especially when the workers are doing varied and independent tasks, which may be expensive to monitor. Secondly, it ensures that the most able and motivated person, if only by a fraction, acquires the better job. Finally it provides competition in the workplace, which may drive people to work harder and perform better, just as competition in a free-market improves quality and price. If one person was ensured a promotion there would be little incentive to work hard but if many people were eligible for the one place it would improve their effort. Tournaments may also ensure that workers stay at the company as they are underpaid at the start but start to reap rewards as they mature and gain experience – the idea of deferred compensation. It may also be in the interest of the company to offer an exorbitant amount of pay for executive jobs to act as a goal for employees lower down in the company.Rank Order Tournaments as Optimal Labour Contracts
This paper, which first suggested the idea of tournament theory, looks at performance related pay. Under conventional systems workers are paid a piece rate - an amount of money that relates to their output, rather than the time they input. Tournament theory suggests that workers can be rewarded by their rank in an organization, suggesting why large salaries are given to senior executives; to provide a 'prize' to those who put in enough effort to garner one of the top positions.The paper invites the reader to consider the lifetime output of a worker at a firm. This output is dictated by two things - chance and skill. The worker can control his lifetime output by investing in skills early on in life,like studying hard at school and getting good qualifications, but a part of that output will be determined by chance. Partakers in the tournament commit their investment early on in life and are unlikely to know each other previously, within the firm they work in, and may not even know each other within the firm. This prevent collusion or cheating in the tournament.
Looking at the tournament in its simplest form, a two player tournament, where there is a prize for the winner and a smaller consolidation for the loser. The incentive to win increases as the difference between the losing and winning prize increases, and therefore the investment of the worker is increased as the difference between the winning and losing prizes is increased. It is in the interest in the firm to increase the spread of prizes. However there is a drawback for the firms. As the workers invest more their costs rise. Competing firms could offer a tournament with a lower spread and attract more workers because they would have to invest less. Therefore there is an optimal prize spread that firms set, high enough to induce investment but low enough so that the investment is not too expensive for the worker. The prize may take the form of extra cash or a promotion - which means more money, as well as entering a higher level of tournament, where the stakes may be higher.
The idea that the prize may be in the form of a promotion explains why presidents are paid significantly more than vice presidents. In one day a Vice-President may be promoted to President of a company and have his pay trebled. Considering piece rates this seems illogical - his output is unlikely to have tripled in one day. But looking at it using tournament theory it seems logical - he has won the tournament and received his prize - presidency.
Tournament theory is an efficient way of labour compensation when quantifying output is difficult or expensive, but ranking workers is easy. It is also effective as it provides goals for workers and incentivises hard work so that they may one day attain one of the coveted positions at the top.