Prestige, Intrafirm Tournaments and Failure Aversion in Corporate Decisions

Abstract

The pervasive "tournament" style of organization is beneficial in that it allows shareholders to place the most talented managers in senior positions. We demonstrate that this benefit is achieved only at a cost: competition for promotions to prestigious positions induces excessive failure aversion among competing managers. Failure aversion emanates from the interaction between the huge rewards promised to the winning manager (the CEO) - the "winner-take-all" phenomenon - and the limited opportunities for managers to influence perceptions about their abilities. Failure aversion in turn corrupts corporate decisions, resulting in distorted project and effort choices. Importantly, it may not be possible to remove the resulting distortions through wage contracts as the organization architecture itself creates implicit contracts that constrain the efficacy of explicit compensation contracts.

JEL Classification: G31, G32, G34