Relative compensation is especially common in settings where absolute productivity is difficult to measure, but where one can rank the performance of workers doing comparable jobs. Thus, the young lawyer works 70-hour weeks in the hope of making partner. Economic theory says that she works until her marginal disutility of effort balances the expected gains associated with her eventual promotion. A similar process operates in the allocation of prizes such as admission into elite colleges. The marginal expected value of studying for the SAT is pretty low if I am a high school star, or if I am unlikely to get into college even if I improve my score.
Relative compensation runs into problems within a heterogeneous workforce.
Our lawyer won't work hard if her current efforts will not appreciably improve the likelihood that she will be promoted. If she is a star, she will advance even if she slacks off a bit. If she is unskilled, if her boss doesn't like her, she may give up. In the presence of such heterogeneity, firms want to sort workers so that each person competes against others of similar competitive standing. I think this is the most compelling commonsense argument for affirmative action.