Tournament Theory (Economics) - Explained
What is Tournament Theory?
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Table of ContentsWhat is Tournament Theory?How Does Tournament Theory Work?Academic Research on Tournament Theory
What is Tournament Theory?
Tournament theory refers to the theory in personnel economics utilized in describing specific situations where wage differences are based on relative differences between individuals as against being based on marginal productivity.
How Does Tournament Theory Work?
The economists, Edward Lazear and Sherwin Rosen invented this theory. This theory has been applied to the practice of law, as well as, to professional sports. This theory has also been applied to writing in that a writer may be fractionally better than another writer, at writing hence, having a better book. But because individuals devote little time to reading, the writer who has the marginally better book would sell far more copies. This research work, which proposed tournament theory, examines performance-related pay. A piece rate is paid to workers under conventional systems. This refers to the sum of money which relates to their output instead of the time they input. Tournament theory opines that workers can be rewarded based on their rank in an organization, explaining the reason why large salaries are paid to senior executives. This is done to provide a prize or reward to workers who put in enough effort to earn a top position. The paper seeks the readers to consider the workers lifetime output in a firm. Two things dictate the output, namely chance, and skill. A worker can control his/her lifetime output by investing in skills at an early stage in life. This can be by studying hard at school and also getting good qualifications, but the chance will be the determinant of an aspect of the output. The tournament participants commit their investment at an early stage in life and would most likely not know each other previously, in the organization they work in, and might not know each other within the firm. This way, cheating or collusion are prevented in the tournament. Viewing the tournament in its easiest form, a tournament involving two players, having a prize for the winner, as well as, a consolation prize for the loser. There is an increase in the incentive to win as there is an increase in the difference between losing prize and the winning one. Thus, the workers investment is increased as the difference between the winning prize and losing one is increased. It is in the firms interest to increase the spread of prizes. But the firms experience a drawback in that, as the workers invest more, there is a rise in their costs. Competing firms can offer a tournament which has a lower spread thus, attracting more workers solely because they will invest less. Therefore, firms set an optimal prize spread, high enough for inducing investment but low enough for the investment not to be too expensive for the worker. The prize may be in the form of either a promotion or extra cash. This means more money and also a higher tournament level, which may have higher stakes. The idea that the prize may take the form of promotion shows why presidents are paid tremendously more than vice presidents. In just a day, a Vice-President of a company may be promoted to the position of President, thereby having his pay tripled. If piece rates are considered, this seems absurd in that his output is most likely not to have tripled within a day. But when it is examined, using tournament theory, it seems logical in that he has won the tournament, and thus, received his prize which is the presidency. Tournament theory is an efficient way of compensating labor when it is difficult or expensive, quantifying labor, but easy, ranking workers. Its effective as it incentivizes hard work and provides goals for workers in order for them to attain one of the top coveted positions one day. A benefit to workers over a piece rate will be that in a case of natural disaster, they will preserve their wage since their output will reduce in absolute terms but remain the same, relative to their colleagues. This implies that workers can maintain their wage in times of disaster. Benefits of the tournament (+) Selecting workers (observe) (+) Offers stability volatility in market (reduce shocks) (+) Decrease variability in pay (commit and credible) (+) Encourage long-run behavior to stay (+) Motivates workers.