Wednesday, February 18, 2004

The Peter Principle - from Marginal Revolution

Remember the Peter Principle? It suggested that we would all be promoted to a level where we are incompetent.

Economist Ed Lazear asks whether we might expect such a result from profit-maximizing businesses. His article, "The Peter Principle: A Theory of Decline," appears in the latest Journal of Political Economy.

Here is the abstract:

Some have observed that individuals perform worse after being promoted. The Peter principle, which states that people are promoted to their level of incompetence, suggests that something is fundamentally misaligned in the promotion process. This view is unnecessary and inconsistent with the data. Below, it is argued that ability appears lower after promotion purely as a statistical matter. Being promoted is evidence that a standard has been met. Regression to the mean implies that future ability will be lower, on average. Firms optimally account for the regression bias in making promotion decisions, but the effect is never eliminated. Rather than evidence of a mistake, the Peter principle is a necessary consequence of any promotion rule. Furthermore, firms that take it into account appropriately adopt an optimal strategy. Usually, firms inflate the promotion criterion to offset the Peter principle effect, and the more important the transitory component is relative to total variation in ability, the larger the amount that the standard is inflated. The same logic applies to other situations. For example, it explains why movie sequels are worse than the original film on which they are based and why second visits to restaurants are less rewarding than the first.

In other words, firms know that you sometimes get lucky, and they set the promotion bar high on purpose. After your promotion you experience a "regression toward the mean", and your observed performance declines in quality, relative to your promotion-winning triumphs. But on average the promotions are still deserved. In other words, the Peter Principle will appear to be true in a well-functioning organization, even when promotions are handed out rationally.

My take: Lazear offers a characteristically nice demonstration of a clever idea. Behavioral factors may skew promotions in less efficient directions, but they will not overturn the central argument. People often overweight recent observations, but of course worker skill levels change through time. It is not obviously inappropriate to weight some observations more than others. Furthermore if people overvalue first impressions as well, the two behavioral effects may cancel to some degree.

Here is an earlier version of Lazear's paper. Thanks to Eric Crampton for the pointer.

very interesting.


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