Tournament versus Team in Executive Compensation

The executive ranking pay gap within the company is a continuous debated topic. Prior research has developed two different theories---tournament and teamwork. Tournament theory advanced by economists Edward Lazear and Sherwin Rosen describes wage differences driven by the desire to have incentives to work hard in order to promote within the company towards the top position. Teamwork theory however suggests that the large gap between higher-level executives and their lower-level executives can reduce motivation and create conflicts within the organization. In this paper, we use the Herfindahl–Hirschman Index (HHI) to measure the distribution of the top five executives’ compensation and abnormal return to measure firm performance. We find no evidence supporting tournament theory over teamwork theory. A portfolio of firms with high concentration of executive pay outperforms that of firms with low concentration pay. However, these results do not stand at the firm level, once we control for other firm characteristics.