Rank-based pay induces effort and risk-taking, but also sabotage.
Lazear and Rosen's 1981 model explains why chief executives earn multiples of their deputies: the pay gap motivates everyone below, so it is priced as an incentive rather than as a wage.
In practice
- A firm with a large gap between director and manager pay gets effort from every manager and a director who is briefed against by four of them.
- A sales team on a winner-takes-all quarterly bonus hits its number and stops sharing leads.