The Rational Choice Myth: The Selection and Compensation of Critical Performers

Abstract:     
Some positions within an organization wield unusual impact over the entity's success. The decision makers who hire these critical performers face a daunting task: to distinguish among closely comparable finalists in a context where small differences in talent can produce enormous outcome divergences. I apply research from psychology and behavioral law and economics to argue that decision makers demonstrate unwarranted confidence in their ability to distinguish among nearly identical candidates. The illusion of validity, representativeness bias, insensitivity to predictability, and the fundamental attribution error all impede decision makers' ability to make these fine distinctions. Once they have made a selection, cognitive dissonance induces inappropriate confidence in the outcome's validity and promotes excessive compensation. Involving a group in the decision may worsen these effects by imbuing outcomes with the false veneer of market legitimacy through social cascades and by discouraging contrary views through excessive consensus or groupthink.

I examine two types of critical performers with these insights: professional baseball players (where individual contributions to the enterprise can be measured directly) and public company CEOs (where they cannot). I conclude that in both contexts, these phenomena produce inefficient selection and compensation outcomes. While the relative absence of externalities argues against mandatory regulation in baseball, I propose changes in private ordering that should improve efficiency. In the corporate context, I argue that regulation is called for and propose a combination of mandatory compensation caps linked to firm size and a reverse auction among CEO finalists to determine the successful candidate.

Number of Pages in PDF File: 67

Keywords: rational choice, rational choice myth, critical performers, baseball, professional baseball, ceo compensation, executive compensation, ceo pay, executive pay, illusion of validity, representativeness heuristic, law of small numbers, social cascade, groupthink, fundamental attribution error

JEL Classification: B41, D70, D80, D81, K00, K12, K22, K31, J33, J38

working papers series