Novak Djokovic, Wimbledon’s 2018 winner, received £2.25 million prize, whereas Rafael Nadal, who lost to Djokovic in the semifinals, receive a paltry £562,000. What explains Djokovic’s almost four-times higher prize? Is Djokovic four-times more talented than Nadal? Was he playing four times harder? Does Djokovic draw four times more spectators, or TV audiences than Nadal (contribution to tournament revenue)? Obviously, No, No, and No. So, what explains the extreme skewness (prize differential) in sport tournaments’ pay?
Economic theory says that people are rewarded for their marginal productivity―that is for their contribution to the organization. A salesperson receives a cut of the sales he/she generate, and an R&D researcher should be compensated for the patents, or new products they help to generate. Seems logical and fair. But it doesn’t explain the 4:1 prize margin of Djokovic over Nadal. Novak Djokovic obviously didn’t contribute four times more than Nadal to Wimbledon’s success in 2018. Something else explains the skewness (large differentials at the top) of tournament prizes (and lotteries too).
Edward Lazear and Sherwin Rosen, two leading labor economists, advanced in 1981 their “Tournament theory” to explain the large top prize differentials of tournaments. Top tournament prizes, say Lazear and Rosen, are not just aimed to compensate winners for their effort and contribution to the tournament. Rather, they serve as an incentive for all tournament participants to strive as hard as they can to reach the top. Suppose the total prize money of a tournament (or a lottery) were equally divided among all players. Obviously, the incentive to win (or buy a lottery ticket) would have been significantly lower than with a skewed prize structure.
Why am I telling you all this? Because now is the time of the year when last year’s compensation of U.S. CEOs is tallied, hotly debated, and often derided. Reed Hastings, Netflix’s CEO, received $36.1M in 2018, whereas the median S&P 500 CEO received “only” $12.4M (Wall Street Journal, May 17, 2019). Is Hastings “worth” three times the median CEO? And what about Robert Iger, Walt Disney’s CEO, who received $65.7M in 2018? Is he twice as able as Hastings? Four times as able as Tim Cook, Apple’s CEO, who took in a measly $15.7M? And do all these multi-million CEO earners deserve so much more than John Roberts, Chief Justice of the U.S. Supreme Court, who was paid $270,700 in 2018? Worse yet, the Journal reports that the 2018 pay of 97 CEOs of the S&P 500 companies increased, while their shareholder returns were in the bottom half of the group. For example, “Dialysis chain DaVita Inc., doubled Kent Thiry’s pay to $32 million while it recorded a negative 29% [shareholder] return…” It seems that CEO compensation is totally unrelated to corporate performance and shareholder return.
This is not new. Ever since I started reading economic literature (and this is a long time ago), academics and pundits lash out at the allegedly extravagant and undeserved CEO compensation, claiming that CEOs pack their boards with friends who award them undeserved pay and perks at shareholders’ expense. And yet, when shareholders vote, annually or biannually, on managers’ compensation―the famous Say on Pay mandatory vote―they approve the compensation at more than 97% of the companies. With but a handful of exceptions (one is Oracle, where the 2017 say on pay vote was only 49% in support of management) shareholders don’t seems to mind the multi-million CEO pay packages. And why would they? When Netflix’s shares returned 39% in 2018, who can resent Reed Hastings’ $36M pay? So, if shareholders are overall satisfied with CEOs’ compensation, what is the reason for the annual fest of criticism and soul searching about CEO pay?
Back to Djokovic, Nadal, and the Lazear and Rosen’s Tournament Theory. The mistake people make in analyzing CEO pay is to focus totally on the recipients of the compensation (CEOs) and their company’s annual performance. (When the legendary Babe Ruth was told once that he made more money than U.S. President Herbert Hoover, he said: “I had a better year than he did.”) A major reason for the large “prizes” at the top of business enterprises’ pay is to motivate all employees to invest in their human capital (education, training) and exert their utmost effort and skill to reach the top of the organization, just as athletes in sport tournaments strive for the top prize. The top prize, accordingly, is, in part, unrelated to the recipient’s effort and contribution in a given year. Rather, it is aimed at other employees (or athletes) as a beacon to motivate human capital investment and effort. Just as Wimbledon’s management doesn’t change the prize structure when the level of the finals isn’t great, companies should not reshuffle pay structure every year.
Please note, I don’t say that CEOs’ pay should be completely detached from enterprise performance and shareholder return. CEO pay should definitely reflect performance and share return, but over several years. And this is clearly the case at most companies, and not just for CEO pay. The median tenure of U.S. CEOs is at an all-time low of five years (for S&P 500 companies). U.S. CEOs are clearly held responsible for their companies’ performance. But it’s a mistake to totally focus on a company’s annual performance when analyzing CEO pay, as so many do. There are other objectives for a skewed corporate pay structure at the top, as Wimbledon’s managers realized when they paid Novak Djokovic in 2018 four times the purse of Rafael Nadal.
 E. Lazear and S. Rosen, 1981, Rank-order tournaments as optimum labor contracts, Journal of Political Economy, pp. 841-864.