Tournament theory's perspective of executive pay gaps

Tournament theory stipulates that large pay gaps provide strong incentives to highly qualified managers, leading to greater effort and improved enterprise performance. This study explores the executive pay gap issue using Taiwanese samples from 2002 to 2004. Certain tournament phenomena occur: pay gaps increase with hierarchy level and the number of contestants. However, we find that tournament–performance relationships are industry-specific. For non-high-tech firms with low levels of R&D intensity, tournament theory works well, and firms are encouraged to increase executive pay gaps, not just executive compensation, in order to improve firm performance. For high-tech firms with high coordination needs, a cautious approach should be taken when considering the tradeoffs between monetary incentives, bottom-line performance, and norms of reciprocal accommodation among top management teams. Large pay gaps do not necessarily improve firm performance. The findings make incremental contributions on the design of proper compensation structures for top management teams.