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Received 27 November 1997
Final revision received 4 December 2000
Key words: executive compensation; tournament theory
This study tests the implications of tournament theory using data on 100 U.K. stock market companies, covering over 500 individual executives, in the late 1990s. Our results provide some evidence consistent with the operation of tournament mechanisms within the U.K. business context. Firstly, we find a convex relationship between executive pay and organizational level and secondly, that the gap between CEO pay and other board executives (i.e., tournament prize) is positively related to the number of participants in the tournament. However, we also show that the variation in executive team pay has little role in determining company performance. Copyright ?2001 John Wiley &Sons, Ltd.
INTRODUCTION
Executive compensation has emerged as a significant theme within the strategic management literature (Beatty and Zajac, 1994; Zajac and Westphal, 1994; Balkin and Gomez-Mejia, 1990; Finkelstein and Hambrick, 1988; Gomez-Mejia, Tosi, and Hinkin, 1987). A comparatively under-researched aspect of this narrative is the empirical importance of tournament theories for explaining executive pay outcomes. The contribution of this paper is a test of tournament theory using a sample of U.K. listed companies in 1998. Our empirical tests are based on the recent work of Lambert, Larker, and Weigelt (1993) and Eriksson (1999).
Various models have emerged for understanding the structure of internal compensation schemes (Lambert et al., 1993). The agency model, for example, posits that owners of the firm (the principal) cannot perfectly observe the actions that managers (the agent) undertake. To motivate the agent to select actions that are in the best interests of the principal, the owners design a compensation contract that makes the agents pay contingent upon observed measures of performance. Hence, traditionally an important empirical test has involved identifying the hypothesized positive relationship between executive pay and company performance (see Murphy, 1999; Lambert et al., 1993). An alternative is the managerial power model (see Lambert et al., 1993, for details of this model).
However, another stream of research, centered on tournament theory, predicts that executives may exert effort in order to be promoted to a better-paid job position. An important implication of this work is that the internal structure of compensation is central to understanding wage setting in...