What potty training reveals about excessive executive salaries.

The economic mysteries of daily life.
Jan. 13 2007 6:52 AM

Urinalysis

What potty training reveals about excessive executive salaries.

This column deals graphically with two distasteful subjects: excessive executive pay, and poop. You have been warned.

Let me start with poop. The elder Miss Harford demonstrated yesterday that she is very capable of controlling her bodily functions. She peed on the floor five times in quick succession in an attempt to divert her mother from feeding the younger Miss Harford.

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Fine. She has the capacity to use the potty, so all that is now required is the right incentive. Chocolate coins turn out to be the sort of currency a 2-year-old understands. Successful use of the potty earns a chocolate coin. It works, and is money well spent.

Yet two days into the contract, problems are emerging. What is "successful use of the potty"? This morning, my nose alerted me to a borderline case: an enormous turd on the sitting room floor, and a tiny rabbit-dropping in the potty. At this early stage, we chose to accentuate (and reward) the positive. In a month's time, I will be less impressed, but can we really move the goal posts then?

Even straightforward incentives can be manipulated. The great pole-vaulter Sergei Bubka repeatedly broke the world record by a centimeter and earned a cash bonus every time. I have visions of a near future in which Miss Harford empties her bladder one drop at a time in order to scoop bagfuls of chocolate coins.

As we are discovering, apparently black-and-white matters of performance can quickly become shades of gray. It is much more tempting to resort to discretion: If we're happy with Miss Harford's potty performance, chocolate coins will be forthcoming.

This sounds a bit like your boss's vague promise of a salary review sometime the year after next. Employees know that bosses are lying weasels and wisely ignore such empty gestures. Daughters know that parents are lying weasels too, and that is why we must keep our incentive payments as unambiguous as possible.

Employers want to offer incentives for good behavior, just as parents do. But how to combine the oh-so-important discretion with the credibility needed to make the promises persuasive?

One possibility is to rely on relative performance. The boss can announce that the best three performers in the office will receive a $1,000 bonus at the end of the year. There is no weaseling out of such a promise, and there is no incentive to give the bonus to bad workers instead of good ones, but the boss retains the flexibility to decide what a good performance actually means.

This sort of payment structure is called a "tournament," and it was described by the economists Sherwin Rosen and Ed Lazear (now chairman of the president's Council of Economic Advisers) in a famous article. Tournaments not only combine credibility with flexibility, they also protect workers from risks outside their control: In a down year, everyone might do poorly, but the people who did least poorly will still be rewarded.

Unfortunately, as Lazear and Rosen were well aware, tournaments also have unwelcome features. They discourage cooperation: One study of Australian companies discovered that workers facing tournament-style pay structures were less likely to call in sick, but also less likely to share tools with each other.

Still, tournament theory explains a lot about office politics and the inequities of working life. The CEO's pay, it turns out, is not designed to motivate him but to motivate potential successors. Think of it as a sort of "lifetime achievement" award for somebody whose productive contribution is long over.

Since we did not have twins, I will not be able to put tournament theory into practice at home. Perhaps the idea is a little potty anyway.

Tim Harford is a Financial Times columnist. His latest book, The Logic of Life, will be published in paperback on Feb. 10.

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