[The Logic of Life] Why your boss is overpaid

Disclaimer: This is my attempt to read The Logic of Life: The Rational Economics of an Irrational world, I am but someone who tries to synthesize understanding from ideas presented in this book.

Continuing the previous post: [The Logic of Life] Why some workplaces are miserable

Some people seem to be rewarded based on luck

Another consequence of the tournament theory is that many people appear to be rewarded simply because they got lucky. This seems irrational, but again, perfectly rational under the context of tournaments. If the nature of work involves luck, then there must be a clear distinction between winners and losers. You wouldn’t spend much efforts on lottery because it’s 100% luck, but if the work was 60% luck and 40% efforts, then you would be motivated to work extra hard to get every inch of that 40%. However, this only applies if the reward is huge. If instead the reward isn’t much, and that luck is a large part of obtaining it, naturally no one would bother.

Tournament theory also demands that pay packages get higher and higher

At the bottom of the hierarchy, the pay package needs not to be too big, because it also provides an opportunity to climb up the ladder. But the closer you move to the top, the more practical incentives (read money) it would take you to motivate you. Things like influences and connections are less valuable, simply because you likely already are in possession of them.

Why your boss is overpaid

The tournament theory explains neatly why workplaces suck, because the application of this theory results in backstabbing behaviors and ostensibly nonsensical pay schemes. Your boss is one beneficiary of these pay schemes, and he gets paid a lot for what seems to be minimal dedication. However, it does make sense in a way: The more money your boss makes, and the less he seems to have to do with it, the more motivated you are to work hard to get to where he is.

“One of the creators of tournament theory, the economist Ed Lazear, has commented, “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.”

Excerpt From: Tim Harford. “The Logic of Life.” Apple Books.

CEO of Walt Disney brought home 800 million dollars over a period of 13 years. If we recall, the author of the book freakonomics worked harder because his reward is based on royalties. The publishers chose this method because it produces more revenue for them. Applying the same logic, the 800 million dollars would be well-spent money if it motivated the CEO to make more than 800 million dollars for the company.

However, giving one individual such a staggering amount of money in hopes that he would be capable of generating more than what is invested does not really make sense. 800 million dollars would have been better invested somewhere else.

If we look at this under the lens of tournament theory, then 800 million dollars doesn’t need to motivate the CEO to generate more than that. Instead it would only need to motivate the CEO would-be-replacements to work hard to generate more than 800 million dollars. And if you think about it, if all of the CEO’s underlings are in a tournament to get to the CEO position, and that the tournament is structured in a way that the outcome always generates revenue for the company, it would make sense to pay the CEO that much money, even if his job is to sit in the office watching porn all day.

This is a very interesting consequence of the tournament theory:

“In this view, CEOs have been removed from the productive flow. They are mere figureheads, more like the Queen, or the recipient of a lifetime achievement award than people who do anything important”

Excerpt From: Tim Harford. “The Logic of Life.” Apple Books.

How your boss is overpaid

Most of the huge CEO payments that you read about are almost always the result of stock options. Stock options simply are options to by shares at a fixed price, regardless fo the shares price on the market. In other words, I can make a lot of money when my stock options give me the options to by shares below the market’s price.

Stock options are highly sensitive to how well a company is doing. This is why CEOs usually get a lot of stock options, because they would feel more motivated to increase the value of stock options by increasing the value of the company.

In the mid-1980, CEOs back then were paid by a variant of ‘split-the-check’. A vivid example is imagining you go to eat dinner at a very fancy restaurant with a lot of people and in the end split the check equally. Rationally, you would try to order lobsters and all of the expensive drinks, because you would only burden a fraction of the total cost. The rest are burdened by everyone else. You can of course try to order something normal, but that behavior would not maximize your own well-being, which in this case your taste.

CEOs were paid by this ‘split-the-check’ check. For every million dollars of a shareholder wealth, a CEO made only 20 dollars in her bonus. Naturally, this means that our bosses used to be paid so little, such that they wouldn’t bother caring about how well the company is doing. They were severely underpaid.

The obvious solution to the ‘split-the-check’ problem is of course to let the CEO own all of the stocks in the company. To be precise, the solution is to encourage CEOs to try to get as much stocks in the company as possible, so that she would feel responsible for increasing the value of the company. The shareholders would only need to sell their shares at a reasonable price in order to motivate the CEOs to generate more values.

Why you are not overpaid

If this scheme encourages CEOs to generate more values, then wouldn’t it make sense to apply the same scheme to all of the employees ? If we let workers sign a contract that link their salary to the share price, then following the same logic it should motivate them to work harder.

This scheme, however, is not rational, because it exposes the workers to enormous risks before any incentives are perceived. If a worker owns 0.1% of a billion dollars company, then he is exposed to a ten million dollars risk, but he personally wouldn’t feel responsible for the values of the stock. This is because a cubicle slave does not contribute the same values, nor his failures cost as much. If a CEO dozes off in a billion-dollars meeting, then he loses ten million dollars for himself. But if a cubicle worker dozes off in his day job, he doesn’t lose anything.

Another reason why this scheme is applicable only CEOs is that, the tournament theory gives us a way to control and measure the performance of workers, which is through structuring a tournament where the winner gets to advance in his career and a huge amount of money, however the CEO has already won this tournament. Therefore his performance is very hard to measure, if the decisions a CEO have to make are easy and straightforward to measure/make, then we wouldn’t need CEOs in the first place.

So, because CEOs are capable of influencing the outcome (winning a billion dollars deal after a meeting), and that CEOs are sensitive to the incentives, it makes sense to link the CEO’s salary closely to the share price. In other words, give CEOs more stock options. This is why CEOs usually get such huge payouts, and why normal workers don’t get to have the stock options as CEOs do.