Pay and Productivity

1. Chapter 11 Pay and Productivity

2. Pay and productivity Employers face a myriad of managerial decisions rooted in the following practical realities 1. Workers differ from each other in work habits that greatly affect productivity but are often difficult (costly) to observe before, and sometimes even after, hiring takes place 2. Productivity of a given worker varies over time or in different environment, depending on motivation

3. Pay and productivity 3. Worker productivity over a given period is a function of innate ability, level of effort, environment (could be a number of things) Being highly productive is usually not just a matter of slavishly following order but rather taking an initiative See Example 11.1

4. The Employment Contract Unlike formal contracts most employment contracts are incomplete and implicit Incomplete in the sense that rarely are all the duties laid out in specific detail Implicit in the sense that they are normally a set of informal understandings that are too vague to be legally enforceable

5. Coping with information asymmetries For markets to operate successfully both buyers and sellers must have access to accurate information Further if a transaction involves a contract, the contract must be enforceable, because it is often advantageous for one of both parties to “cheat” by reneging on promised ex post Opportunities for “cheating” are created when there are informational asymmetries

6. Coping with information asymmetries Job applicants know more about themselves while employers know more about the job - hence there exists an incentive for workers to overstate their qualifications while employers may understate the rigors of the job Lawyers may “overbill” clients Employer may refuse a promotion previously promised to a worker Some of it may have to do with something external

7. Coping with information asymmetries A salesman may not do as well because the market is bad rather than any lack of effort On the other hand the employer may not necessarily be able to distinguish if it is the market that is down or if the salesman has been “goofing off” There are of course formal penalties in many cases for reneging on one’s commitments However “cheating” must be proven

8. Coping with information asymmetries A salesman may not do as well because the market is bad rather than any lack of effort On the other hand the employer may not necessarily be able to distinguish if it is the market that is down or if the salesman has been “goofing off” There are of course formal penalties in many cases for reneging on one’s commitments

9. Coping with information asymmetries However in many cases formal avenues may not be available or applicable How do you transact with the “right kind” of person? Suppose employer wishes to hire workers who are willing to defer current gratification for long term gain, merely asking may not be enough Offer a package like this - potential applicants who discount future payoffs heavily will not accept

10. Coping with information asymmetries Or as in chapter 9 employer can use a signal such as educational attainment since as we saw people who discount future payoffs heavily are less inclined to invest much in education. Only those who value future payoffs will do so So the essence of signaling is the voluntary revelation of the truth about oneself not verbally but by actual acts So in many cases, the nature of the relationship leaves scope for ex post “opportunistic behavior”

11. Coping with information asymmetries The challenge then is to design contracts which minimize the incentive on both sides to renege ex post The key to self-enforcement is that there be losses imposed on the cheater that do not depend on proving to a third party that cheating occurred Consequently self-enforcement requires that both employer and employee derive more gains from honest continuation of existing relationship than from severing it

12. Coping with information asymmetries For employees to be paid more than they could get elsewhere, yet produce more profits for the employer than outsiders could, there must be a “surplus” generated by the employment relationship To discourage specifically trained workers from leaving the employer must pay a wage above what the worker could get elsewhere; at the same time the MRP of the worker must be above the wage

13. Coping with information asymmetries The gap between a worker’s current wages and the marginal product of that worker is a surplus that can be shared between the employer and the employee Division of the surplus is essential because if one party gets the entire surplus then the other party has nothing to lose from terminating the relationship Firms can also create a surplus by investing in reputation

15. Motivating workers Very often the goals of the worker and the employer are at odds with one another Employer wishes to maximize profit - the difference between revenue and cost Worker wishes to maximize utility which is the difference between wages and the disutility of work Maximizing profit requires greater effort which in turn increase the disutility of work

16. Conflicting goals Employer: Max F(e) - W Output = F(e) with e = effort and W = wages Employee: Max W - V(e) V(e) = disutility (cost) of effort

17. Motivating workers Supervision Disadvantages? Costly Sometimes not feasible Does not take advantage of comparative advantages in the sense the Supervisor may then do the job himself! Supervisor (if not owner) may require supervision himself Three elements characterize an employers’ compensation scheme

18. Compensation Plans 1. Basis of pay 2. Level of pay in relation to pay for comparable workers elsewhere 3. Sequencing of pay over worker’s careers

19. Motivating workers Pay worker’s on the basis of output? Places entire risk on worker especially of output if affected by factors outside of worker’s control - such as weather or market conditions Pay fixed wage? Creates a strong moral hazard problem on the part of the worker who has no incentive to perform

20. Why not piece rates? A “rent” is in the nature of a lump-sum tax and does not distort incentives Then why have output or profit sharing? Graph to show how output under rent is optimal “Sharing” distorts incentives - you get a fraction of additional output Graph to show this

21. Risk aversion What does this mean? Example Two lotteries Prob 1/2 of getting $100 and 1/2 of getting $20 Prob 1/20 of getting $1200 and 19/20 of getting $0 Choose one

22. Benefits of sharing Returns to employer = psG +(1-p)sB If this is set equal to the employer’s returns from fixed rent then S = R/[pG+(1-p)B] Returns to employee same as well But the employee is risk-averse So what does he prefer?

23. Benefits of sharing Two states of nature - Good (G) and Bad (B) with probability “p” and “1-p” Fixed rent R In good state employer gets G-R otherwise B-R Suppose sharing is introduced - share of employer “s”

24. Benefits of sharing Returns to employee lower under “good” state but greater under “bad” state Compare returns G-R and (1-s)G in “good” state B-R and (1-s)B in “bad” state (1-s)G < G - R (1-s)B > B - R Derive this result

25. Benefits of sharing Why does this matter? Because tenant is risk averse Given a choice between two lotteries - the agent prefers the one with lower variance Graph of this observation

26. Compensation Plans Fixed time based wages Piece-rate pay - based on amount of output is common A variant of piece-rate is standard time for a specific job for a fixed amount - if it takes longer then revert to hourly wages Commissions Gain-sharing plans - group incentive plan Profit-sharing and bonus - also group incentives

27. Compensation Plans Workers can be paid for their time or for their output or a combination of the two The latter has the advantage that in this case the goals of the worker and the employer are more closely aligned However the large majority of compensation schemes pay workers for their time and not output

28. Motivating workers Problems with measurement of effort as well - sometimes it may not be possible to infer anything about effort put in by looking at the final output Also the final output may not measure other aspects of the employee’s job performance which are desirable but hard to measure - like friendliness

29. Motivating workers in a group While workers definitely care about personal compensation and personal utility, one’s standing in a reference group is often of some concern to workers The importance of the group in motivating individual workers presents both problems and opportunities

30. Motivating workers Issues of fairness Framing issues - study showing “salary” creates more of an entitlement than “bonus” Reference point - context of the decision to cut wages makes a big difference The critical issue is how others in the group are treated

31. Motivating workers Group Loyalty and organizational pride However in group production there is very often a “free rider” problem Employers with highly productive workers almost always pay attention to policies that foster organizational loyalty The widespread human tendency to identify with a group can be a powerful motivator for high productivity

32. Compensation Plans Problems with group incentive plans such as revenue sharing or profit sharing? Yes, because there are incentives to shirk Every worker has an incentive to shirk as long as he/she feels that everyone will expend full effort

33. Compensation Plans Assume four identical members in the group Each works 8 hours for a max of 32 hours Total output is $320 Each worker gets $80 ($10 per hour) Cost per hour of working is $4 Net gain to each worker = $6 per hour Suppose one worker shirks completely

34. Compensation Plans Total hours = 24 Total output = 240 Each gets $60 (7.50 per hour) But consider the shirker He gets entire $7.50 since he has zero cost of effort As long as the cost reduction is greater than the decline in output share incentive to shirk

35. Compensation Plans Output based pay creates uncertainty especially if it depends on factors beyond the control of the worker Risk averse workers therefore prefer time based compensation rather than output based Only those workers who expect their earnings to exceed what they could earn under a time based plan would be willing to accept an incentive (output based) scheme

36. Compensation Plans Workers who gain most from piece rates are those who have motivation or ability above the average Employees choosing to work for incentive contracts signal above average productivity Both worker risk aversion and the signaling aspect on individual incentive pay plans imply that workers earn more than comparable workers paid on the basis of time Studies actually bear out this conclusion

37. Compensation Plans Employer Considerations: If workers accept incentive contract such as piece rates then they bear the risk of low output and require much less supervision While time-based payments require greater supervision and employers bear the risk Typically employers are risk-neutral and are more willing to bear the risk especially since they have greater assets and can weather periods of lean output

38. Compensation Plans Pay for output: Individual Incentives From the employer’s perspective an incentive contract is ideal since it results in goal alignment However does create perverse incentives Competitive nature conflicts with group loyalty and also leads to myopic behavior which concentrates on short term gain rather than long term rewards Also problems of equipment misuse

39. Compensation Plans Pay for output: Individual Incentives In setting “piece rates” the question arises as to what rate to set Besides on the emphasis on quantity over quality in piece rate pay another problem arises when the employee performs more than one task - some measurable some non-measurable. Basing pay on the measurable aspects induces workers to ignore the non-measurable parts Example 11.3

40. Compensation Plans Pay for output: Group Incentives Strong free-rider problems associated with group incentive schemes A common example of incentive pay based on group results is the widespread use of profit based bonuses in the compensation of top executives One major issue here is however the measurement of performance Also paying yearly bonuses leads to conflicts with long term goals

41. Compensation Plans For this reason many corporations tie a portion of their senior executives’ compensation to company performance over a number of years Stock options are a good way to align the interests of managers with the shareholders (owners) However studies show that yearly pay of CEO’s not very responsive to changes in share values; but those companies which tie executive compensation to long term firm performance outperform others

42. Compensation Plans Given the problems of risk aversion and measurement in incentive pay most employers opt for time-based pay As we mention before this creates moral hazard problems In motivating workers in such cases employers often use merit-pay plans which aware larger pay increases each year to better performers

43. Compensation Plans Problems of measurement or issues of unfairness can be alleviated by the use of “rank order tournaments” or basing merit-pay on relative performance and not absolute performance Level of pay itself might affect the size of the surplus to be divided - in the sense that studies find that the level of productivity rises in the level of pay Thus with higher pay there is a greater divergence between MRP and wage creating a larger surplus

44. Compensation Plans Several reasons why higher wages are thought to increase level of productivity One reason relates to type or worker With higher wages one improves the pool of candidates and therefore increases the probability of hiring better workers Second higher wages reduce the incentive to quit This might induce employers to provide greater training

45. Compensation Plans Also if wages are substantially higher than what the worker can get in an alternative employment then that reduces shirking on part of the workers since the penalties of getting fired are larger

46. Productivity and the sequencing of pay Efficiency wages Paying workers a greater than equilibrium wage rate Reduces incentive to shirk Creates commitment But has both benefits and costs Persistence of unemployment in the face of labor surplus may be due to efficiency wages

47. Productivity and the sequencing of pay Underpay workers early in their careers and overpay later This sequence increases worker productivity and enables firms to pay higher present values of compensation than otherwise

49. Productivity and the sequencing of pay This pay sequence will most appeal to workers who intend to establish a long term relationship and work diligently enough to avoid being fired before their deferred rewards can be collected Thus in the presence of asymmetric information a pay scheme featuring deferred compensation acts as signaling device about the type of the worker

50. Promotion Tournaments Another form of worker motivation in the context of internal labor markets is promotion tournaments Uncertain outcome Relative performance rather than absolute performance Big difference between winning and losing

51. Promotion Tournaments Another form of worker motivation in the context of internal labor markets is promotion tournaments Uncertain outcome Relative performance rather than absolute performance Big difference between winning and losing

52. Career Concerns and productivity Allocate labor towards measurable aspects and ignore non-measurable aspects in an attempt to influence other employers Piece rates have the advantage of solving this moral hazard problem but then there are problems in figuring out a good benchmark since workers always have an incentive to over-report the time required to finish a job

53. Career Concerns and productivity However if workers are mobile across jobs then then they may be less concerned about the current employer’s future actions and will be more productive under piece-rate schemes As far as sequencing of effort is concerned there are two general incentives - current pay and future promotion

54. Career Concerns and productivity Young workers more motivated by future promotion rather than current performance incentives Relatively low level of reliance on current performance will not reduce productivity as long there are strong career concerns In fact if there is asymmetric information and workers know that then this might elicit greater effort on part of the workers in an attempt to be noticed

55. Applications:Three Puzzles Why do earnings increase with job tenure Why do large firms pay more Monopsonistic behavior by employers

56. Why do earnings increase with job tenure Wages not only increase with age but they also increase with an increase in the length of time spent with the employer workers are paid their MRP and wages rise as their productivity rise Increased productivity may arise from on the job general training which depresses earnings at the beginning but raise them later

57. Why do earnings increase with job tenure Firm specific investments are a second reasons this joint investment creates a bigger divisible “surplus” A third reason is the delayed compensation incentive scheme

59. Why do large firms pay more? While 1/4 of workers work with firms with less than 25 workers, a 1/3 work in firms with more than a 1000 workers This latter group is better paid They earn 12% more than those with same measured human capital characteristics who work in the smaller firms

60. Why do large firms pay more? While 1/4 of workers work with firms with less than 25 workers, a 1/3 work in firms with more than a 1000 workers This latter group is better paid They earn 12% more than those with same measured human capital characteristics who work in the smaller firms

61. Why do large firms pay more? Larger firms use more interdependent production processes which require greater discipline and are therefore more regimented - this might create a compensating wage differential More opportunities in a career “job ladder” creating long term commitments Efficiency wages are more effective when there is a long term attachment because the workers’ losses from being terminated rise both with the wage level and the length of the future expected tenure

62. Why do large firms pay more? Larger firms have more opportunities for adopting efficiency wages, deferred compensation plans and economic tournaments They may also need to since owing to large size monitoring is much more difficult and/or costly Job vacancies more costly for larger firms

63. Monopsonistic behavior by employers Earlier we saw that employment reductions in the face of minimum wage increases have been puzzlingly difficult to document in a clear and convincing way One explanation is that the basic theory is correct but measuring employment impact of minimum wage correctly difficult

64. Monopsonistic behavior by employers Another explanation is that the simple model of employer behavior is incomplete As we saw in Chapter 3, during our discussion of monopsony, if firms face a labor supply curve that is upward sloping instead of horizontal then minimum wage legislation may actually not lead to job losses

65. Monopsony and MinimumWage

66. Monopsonistic behavior by employers This chapter suggests another reason why larger firms might find the labor supply function to be upward sloping As firms grow in size they find it more costly to monitor worker effort or to measure an individual worker’s contribution to profit. To cope with this the larger a firm becomes, the more it must pay in efficiency premiums to elicit this effort. The need for an increased wage as the firm hires more workers means that the firms will face an upward sloping labor supply function

67. Monopsonistic behavior by employers Because the essence of labor market monopsony is an upward-sloping labor supply function, monopsonistic behavior can be produced by these rising monitoring costs In the case of mandated wage increases the firm’s total costs rise and its profit fall but the net marginal cost of hiring labor might go down

68. Monopsonistic behavior by employers Marginal labor costs can fall because with higher wages workers are more afraid of losing their jobs and thus need less supervision to be more productive The possibility that marginal costs of labor may fall imparts some uncertainty to predictions about how employment levels with respond to mandated wage increases