Tournament Incentives and Firm Operational Efficiency

Abstract

We document new evidence that the gap in total compensation between the chief executive officer (CEO) and other top executives (VPs) is negatively associated with firm operational efficiency. While prior research finds that such a pay gap, known as a tournament incentive, incentivizes VPs to adopt riskier investment policies, we show that a high pay gap is counterproductive to firm efficiency. The negative association with operational efficiency holds under a series of robustness tests, including regressions with alternative measures for pay gap and additional control variables, firm fixed effects and instrumental variables regression, and change analysis. We show that the negative impact of pay gap on operational efficiency stems from two channels: (i) inefficient decisions about inputs that determine efficiency and (ii) the propensity for overinvestment in tangible and intangible assets. Our evidence confirms concerns expressed in the market that high pay gaps can have adverse effects on overall business performance.

Keywords: tournament incentive, Operational Efficiency, tournament theory