Why your boss is overpaid

It is a typical 'Dilbert' strip. The boss announces, "Our CEO has voluntarily slashed his pay from $6 million per year to $4 million. In a written statement, he said he wants to 'share the pain.' Do you feel better now?" A downtrodden intern replies, "I make my underpants from sandwich bags."

But that's office life, is it not? Bosses make obscene sums of money, while downtrodden cubicle slaves toil almost without reward. It might seem insane, but economists have a surprise for us: The insanity reflects nothing more than cool economic logic. There is method in the madness.

In pictures:
Most overpaid CEOs
Best-performing CEOs

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."

After all, managers find it hard to spot an excellent performance. It is a rare job where workers can be fairly paid according to some objective criteria.

There are some exceptions, of course. Critics and audiences may disagree about the literary merits of Dan Brown's bestseller, The Da Vinci Code. Yet from a business point of view, the success is easy to measure. He has sold about 40 million books and is rewarded with a payment for each one.

In pictures:
Top-earning CEOs from abroad
Top-earning female CEOs

Another superstar, tennis champion Roger Federer, has qualities that cannot be so easily calibrated. So instead of trying to measure his performance in objective terms, as Dan Brown's is measured, we measure it in relative terms. If Federer beats Andy Roddick in the final of the US Open, he has succeeded.

Federer is not paid to try hard, nor to produce objectively brilliant tennis. He is paid for beating other players. Yet that is enough to get the best out of him. It is likely that employers have long since noticed that paying for relative performance can be just as good as trying to pay for absolute performance.

The economists Edward Lazear (recently appointed to chair the Council of Economic Advisors) and the late Sherwin Rosen argued, in a hugely influential paper published 25 years ago, that tournaments are an integral and often invisible part of the workplace. Workers are frequently ranked relative to each other and promoted not for being good at their jobs but for being better than their rivals. It is a natural response to the difficulty of true performance pay.

Tournaments also help protect workers against risks they cannot control. Companies can be affected by recessions, unexpected competition and hurricanes. As long as every worker is equally affected, the incentives to try hard remain the same. Trying to encourage performance through, say, stock options would unnecessarily expose workers to risks without really encouraging them to work harder.

In pictures:
Youngest CEOs
CEOs with biggest pay increases

Promotion tournaments sound sensible: Good workers are promoted, less capable workers are not. Yet the widespread use of tournaments also goes a long way toward explaining the frustrations of office life.

First, one way for you to win is for your colleagues to lose. Companies that rely too heavily on competition to determine promotions may find that their employees discover that the most efficient way of winning a promotion is by sabotaging the efforts of their rivals. You don't need economic theory to spot that risk.

The second, and more counterintuitive, prediction of tournament theory is that the more luck is involved in work, the larger the pay gaps should be between the winners and the losers. If Jack's promotion is 90 per cent luck and 10 per cent effort, Jack may be inclined to goof off--unless, of course, the rewards for promotion are absolutely astronomical. And they sometimes are.

Tournaments also demand increasingly absurd pay packages as workers get higher up the hierarchy. At the lowest level, a promotion may not need to carry much of a pay increase, because it opens up the possibility of future, lucrative promotions. Nearer the end of your career, only a fat check is likely to spur you on.

Finally, tournament theory also helps to explain why insiders, not outsiders, get cushy jobs. You thought it was all about the old-boy network, but in fact, the logical reason for promoting insiders is clear: These jobs are designed to keep your workforce motivated.

Lazear and Rozen's tournament theory has stood the test of time and been supported by many subsequent pieces of empirical research. It also passes the smell test: The more grotesque your boss's pay and the less he has to do to earn it, the bigger the motivation for you to work for a promotion. As Lazear wrote in his book, Personnel Economics for Managers, "The salary of the vice president acts not so much as motivation for the vice president as it does as motivation for the assistant vice presidents."

Economists don't even pretend that your boss deserves his salary. Suddenly, everything is clear.