Lecture 10 Pay and Productivity

Transcription

1 Lecture 10 Pay and Productivity 1

2 Introduction Ensuring that your employees take actions that are in the best interest of the firm can be a difficult problem One of the more difficult problems is ensuring that managers take actions to enhance the wealth of shareholders How you compensate employees can have a significant impact on the profitability of the firm 2

3 Introduction We want to see how we can structure employment contracts to take a number of factors into account. 3

4 Introduction 1. Almost impossible to write a formal contract that explicitly spells out how a worker should behave in every situation. 2. Workers can vary the amount of effort they put forth and this will affect their output. 3. Workers differ in ability. 4. Other factors beyond the worker s control affect output. 4

5 Introduction 5. It is costly for the employer to observe the exact level of effort put forth by the workers. We will discuss various strategies that employers adopt when designing compensation systems for their employees to take these factors into account. 5

6 Topics to be Discussed Principle-Agent Problem Employment Contract Piece Rates vs. Time Rates Tournaments Delayed Compensation Efficiency Wages 6

7 Principle-Agent Problem The main problem we want to consider is what is known as the principle-agent problem. Agency problems occur when the actions of one person (the agent) can affect the wealth of a second person (the principle) and the principle cannot easily observe the actions of the agent. 7

8 Principle-Agent Problem In the typical employer-employee relationship the employer is the principle and the employee is the agent. In most employer-employee relationships the employee can take actions that affect the wealth of the employer. Vary amount of effort and type of effort. Steal from the firm. Example 8

9 Principle-Agent Problem In the owner/managerial relationship owners want the manager to maximize profits conditional on a given level of risk Managers may be interested in other things such as: Maximizing their own wealth Minimizing their personal exposure to risk Enhancing their own career 9

10 Principle-Agent Problem Throughout this discussion we will assume that employees prefer to put forth the minimum level of effort (amount of effort that maximizes utility). Effort is costly Employer wants the worker to work as hard as possible to produce the most output. 10

11 Principle-Agent Problem Employer uses the employment contract to structures how a worker gets paid to try and overcome the principle-agent problem. 11

12 The Employment Contract Two types of employment contracts. 1. Formal contracts This contract explicitly specifies various aspects of the employment relationship. Show up when scheduled, don t steal from the firm, when and how you get paid. Formal contracts are legally enforceable. 12

13 The Employment Contract Two types of employment contracts. 2. Implicit contracts These are common understandings between employers and employees about how employees should behave. Work hard, perform the task that the employer requests, don t insult the customers, etc. These are frequently difficult to enforce. 13

14 The Employment Contract It is very costly to write a long formal contract. Give up flexibility if everything is formally spelled out. 14

15 The Employment Contract Two ways to enforce implicit contract, monitoring workers or making them selfenforcing. Monitoring workers requires the firm to spend resources to check whether employees are working hard, etc. Self-enforcing means that it is in the employers and employees best interest to obey the terms of the contract 15

16 Piece Rates and Time Rates In order to make a contract self-enforcing, employers want to design compensation schemes which motivate workers to work hard. Two broad classes of compensation schemes are: piece rates and time rates. 16

17 Piece Rates and Time Rates Piece rates are contracts where workers are paid for every unit of output they produce. Time rates are contracts where workers are paid for every hour they work, regardless of the amount of output they produce. In the long run workers can be fired or not promoted if the firm thinks they are not working hard. 17

18 Piece Rates and Time Rates Most workers are paid based on how long they work In some industries workers are paid piece rates: 75% of workers producing footwear, men s shirts, or iron and steel are paid piece rates. Many workers are paid by both time and piece rate Base pay per hour or day and then additional pay based on output 18

19 Piece Rates and Time Rates How does a firm decide what portion of a workers compensation is based on a piece rate and how much is based on a time rate? If a firm offers a piece rate then the worker s wage equals her marginal product. 19

20 Piece Rates and Time Rates However, the firm needs to observe exactly how much the worker produces. If it is difficult to observe output then the firm has to spend resources trying to measure the worker s output. This makes it less likely they will pay piece rate. 20

21 Piece Rates and Time Rates It also needs to be the case that increased effort by the worker has to result in increased output. If changes in output are affected by other things the workers can t control weather, state of the economy then the worker s pay will not be closely tied to their effort. 21

22 Piece Rates and Time Rates With time rates the firm pays the worker for the number of hours they work but terminates workers if they do not work hard. This means the employer/supervisor has to spend time monitoring worker effort. This can be costly, especially if there are a large number of workers. If a supervisor spends all her time watching a worker, they could do the job themselves. 22

23 Allocating Effort to Jobs Suppose a worker is paid a piece rate. How does the worker decide how much effort to devote to the job? Producing more output requires effort and effort is costly and lowers utility. If the worker works harder they produce more output and get paid more money this increases worker utility. 23

24 Allocating Effort to Jobs Worker compares the costs and benefits and choose the level of effort that maximizes utility. Suppose that worker is paid r dollars for every unit of output produced. Then r is marginal revenue from effort. Assume it is constant. 24

25 Allocating Effort to Jobs Let marginal cost measure the cost of putting forth effort to produce one more unit of output. Suppose MC is rising with the level of effort. 25

26 Allocation of Effort by Piece Rate Workers Dollars MC Worker puts forth effort until MR=MC at q* r MR q * Output 26

27 Allocating Effort to Jobs More able workers will be those that can produce effort at lower cost. These workers should optimally put forth more effort, produce more output and make more money. 27

28 Allocation of Effort by Piece Rate Workers Dollars MC MC able More able workers have low MC and put forth more effort. r MR q * q able Output 28

29 Allocating Effort to Jobs How much effort do time rate workers allocate? Suppose there is a minimum amount of effort that the employer can easily observe q min Then time rate workers will put forth q min effort. Anything else would not be optimal. Time rate workers will be paid r x q min 29

30 Sorting Workers into Firms Suppose there are two types of firms, one offering piece rates and one offering time rates. Which type of worker will work for which firm? Suppose that workers suffer no disutility by providing q min level of effort. Then all workers in the time rate job will get the same level of utility. 30

31 Sorting Workers into Firms High ability workers produce more output with the same level of effort as low ability workers in piece rate jobs. High ability workers obtain higher utility in piece rate jobs than low ability workers. Workers sort themselves into firms based on their ability. 31

32 Effort and Ability of Workers in Piece-Rate and Time-Rate Jobs Utility rq min Worker B is higher ability and works in firm paying piece rate Piece-Rate Workers Workers with ability below x* work in firms paying timerates Time-Rate Workers Worker A x * Worker B Ability 32

33 Sorting Workers into Firms Empirical evidence suggest that workers being paid piece rates are more productive and receive higher wages. In the footwear industry piece-rate workers earn 13 percent more than time-rate workers. Piece-rate workers that produce men s and boy s suits and coats earn 15 percent more. Piece-rate workers in auto repair shops earn 20 percent more than time-rate workers. 33

34 Sorting Workers into Firms Don t know whether these differences are related to ability differences or different incentives. 34

35 Problems with Piece Rates Given the benefits of piece rates, why don t more firms use them? There are some problems. 35

36 Problems with Piece Rates 1. Piece rates are not effective when output depends on team production. Could pay the whole group a piece rate. Could lead to free rider problems. 2. Piece rate emphasizes quantity of output, not quality or other aspects of job. 3. Piece rates make employees salary more variable, which workers may not like. 36

37 Piece rates and risk aversion Many employees dislike variability in pay Call this being risk averse Believe that firms are risk neutral Shareholders/owners have more ability to diversify the risk Pushes us towards less of the pay based on output and more based on time 37

38 Problems with Time Rate Obvious problem with time rate is that it induces workers to put forth minimum effort. Typical contract has elements of both piece rate and time rate. Firms also tie increases in pay and promotions to worker performance to induce workers to work harder. 38

39 Tournaments For some workers, especially managers, observing absolute output can be very difficult. Managers can have affect on all workers below them. However, it may be fairly costless to observe relative output. How one manager performs relative to another manager. 39

40 Tournaments In situations like this firms may, in effect, set up a tournament for managers. Tournament Managers at a lower level compete with each other for promotion to the next level. Promotion based on relative performance. Fewer positions at the higher level than the lower level. Winner gets a large raise. 40

41 Tournaments Example: Chris and Ken are competing for a promotion. They are identical same ability. Winner gets the promotion and a big raise, Z 1st, loser keeps the same job gets a small raise, Z 2nd. For both it is costly to put forth more effort more effort lowers utility and the cost is an increasing function of effort. 41

42 Tournaments Both decide on the optimal amount of effort to put forth by comparing the marginal cost of the effort with the marginal return. Marginal return is given by the difference in income between winning and losing: Z 1st - Z 2nd. 42

43 Allocation of Effort in a Tournament Dollars Workers choose effort so that MR=MC MC Chris & Ken Firm can get workers to work harder by increasing the prize MR high MR low E low Effort E high 43

44 Tournaments In this example Chris and Ken are identical so both put forth the same level of effort. The winner will be decided by some random event. Being in the right place at the right time. If one has more ability can put forth the same level of effort at lower cost then the more able worker will work harder. 44

45 Allocation of Effort in a Tournament Dollars Ken has higher ability and works harder MC Chris MC Ken MR E Chris E Ken Effort 45

46 Tournaments The model makes clear that the level of effort is a function of the size of the prize. Workers work harder for a bigger prize. Also must be true that increased effort leads to an increase in the probability of winning the tournament. This is for a single round of a tournament. Most tournaments have many rounds. 46

47 Tournaments Prize for winning each successive round must increase in order to get workers to continue to work hard. At the U.S. Open tennis tournament, the winner gets $3.0M; 2 nd place, $1.45M; 3 rd place $750K. Among large U.S. firms persons promoted to CEO receive, on average, a 142 percent pay increase, while persons promoted from one-level of VP to another receive a 43 percent pay increase. 47

48 Problems with Tournaments There are problems with tournaments. Instead of increasing their efforts workers could spend time trying to sabotage efforts of their competition. This is an especially big problem when team work is important to success. Firms where cooperation is important will pay similar people the same so they continue to work together. 48

49 Problems with Tournaments If workers have the same ability so the outcome is random, then workers may agree not to work too hard. What do you do with the losers? How do you make sure the winners (CEO) continue to work hard? 49

50 Application: Compensation of Executives Executives/Managers in large corporations represent the classic principle-agent problem. Executive is the agent. Owner/shareholder is the principle. It is difficult for a shareholder to observe whether an executive is working hard and maximizing shareholder wealth. How should we compensate executives? 50

51 Application: Compensation of Executives To begin with we set up a tournament to make sure executives work hard. Promotion from manager to junior VP to senior VP to CEO. At each level there are fewer and fewer positions. Prize gets larger at every level with a very large prize at the top. 51

52 Application: Compensation of Executives How do we ensure that CEOs continue to work hard? Set up a piece rate or pay for performance contract. Tie part of a CEO s compensation to the output or profit of the firm as well as pay the CEO in stock. 52

53 Application: Compensation of Executives In the late 1980s there was a study showing that CEOs pay was not closely tied to the company s stock or shareholder wealth. The CEOs salary increased by only 2 cents for every $1000 increase in shareholder wealth. Is this large or small? 53

54 Application: Compensation of Executives This generated calls for CEO compensation to be more closely tied to changes in shareholder wealth. In percent of CEO pay was in the form of stock, by 1996 that had risen to 23 percent. A study in 1994 found that a 10 percent increase in the value of a firm s stock increased CEO wealth by $1.25 million. By 2009 CEO salary increased $35 for every $1000 increase in shareholder wealth. 54

55 Application: Compensation of Executives Tying CEO pay to stock performance appears to have some effect firms where stock or stock options are a larger proportion of executive pay appear to experience greater increases in corporate wealth. Want to focus on gains over the long-run. Hard to do. 55

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57 Application: Compensation of Executives There are some problems in tying CEO wealth too closely with shareholder wealth. CEOs may benefit too much from things beyond their control such as the overall performance of the economy. May lead the CEO to avoid riskier, but potentially more profitable, projects. CEOs will focus on short-term profits or take efforts to inflate profits to increase stock price. 57

58 Work Incentives and Delayed Compensation There are other ways a firm can structure a contract to elicit higher effort and less shirking from workers. One way is to use the fact that workers will work for the firm for a number of years Adopt an upward sloping age earning profile. 58

59 Work Incentives and Delayed Compensation Suppose the worker s value of marginal product is constant over time. Also suppose that the firm can only periodically monitor the worker. The worker can choose not to work very hard, or to steal from the firm, and will not be caught when she is not being monitored. 59

60 Work Incentives and Delayed Compensation The firm can get the worker to work hard, and not steal, if they offer to pay the worker a wage that is initially below the worker s MP but then rises over time till the worker is being paid a wage greater than their MP. If the worker is caught cheating or not working the worker is fired. 60

61 Constant Wage vs. Upward-Sloping Wage Earnings If area of ABD=BEC the worker is indifferent between constant wage and upward sloping wage C D B E MP A t* N Years on the Job 61

62 Work Incentives and Delayed Compensation As long as they have the same present value, workers should be indifferent between constant wage and an upward sloping wage profile. Two different contracts will provide different incentives. With constant wage workers will put forth minimum effort. If they are fired they can get a similar job somewhere else. 62

63 Work Incentives and Delayed Compensation With an upward sloping wage profile worker will not shirk and will work hard. There is some chance they will get caught cheating and fired. If the worker is fired before t* then the worker has contributed more to firm output than they have been paid. Think of the worker posting a bond that will only be returned if they work hard. 63

64 Work Incentives and Delayed Compensation So an upward-sloping age-earnings profile gets the worker to work harder than a flat age earnings profile. Note, with an upward sloping age-earnings profile the firm needs the worker to retire at N but the worker does not want to. 64

65 Constant Wage vs. Upward-Sloping Wage Earnings Firm need the worker to retire at N, worker does not want to. C D B E MP A t* N Years on the Job 65

66 Work Incentives and Delayed Compensation When mandatory retirement was legal it was easy to get the worker to retire the firm simply made them retire at a certain age. Now it is harder. Firms still try and get workers to retire at a certain age Offering a pension that pays off starting in a certain year raises the opportunity cost of working. Offering early retirement buy-outs. 66

67 Potential Problems with Delayed Compensation Worker is only willing to accept such a contract if they are certain firm won t fire them after t*. Firm will not be able to hire more workers if workers discover they cheated previous workers. There is still the chance that the firm will go bankrupt and won t be able to pay back the worker. 67

68 Potential Problems with Delayed Compensation Only works if workers count on working at the firm for a number of years. 68

69 Efficiency Wages So far we have been talking about ways to change how or when we pay wages to get workers to work harder or produce more output. Now we want to consider the possibility that how much we pay workers may affect how hard they work and how much output they produce. 69

70 Efficiency Wages Consider two cases 1. Firm in a developing country. Most of their workers are living at subsistence levels. Workers that are paid a higher wage will be able to get more to eat, become stronger, and therefore are able to work harder and longer and produce more output. 70

71 Efficiency Wages Consider two cases 2. A firm could pay a worker an above market wage. If a worker does not work hard or gets caught cheating and is fired the worker will receive a lower wage in their next job. Therefore, the worker works harder and is more honest to avoid getting fired. 71

72 Efficiency Wages In both cases worker productivity is higher and they produce more output. Obviously if the firm pays a higher wage they have higher costs. The firm trades off the benefit of the higher wage the increased output with the cost of the higher wage the additional amount they must pay the workers when deciding whether to pay higher wages. 72

73 Efficiency Wages The firm chooses the wage such that the marginal cost from the higher wage exactly equals the marginal gain in the output of workers. This wage is known as the efficiency wage. 73

74 Determining the Efficiency Wage Output Slope Efficiency At Y an of increase a wage line from is in where output the origin a with line an shows from increase the average origin in the is wage product tangent is larger per to dollar total paid product than to the a curve increase worker. at the in cost. highest point. Z q e X Total Product Curve Y At Z a decrease in the wage will lead to a smaller decrease in output than the decrease in cost. 0 w w e Wage 74

75 Efficiency Wages Optimal wage is where a 1% increase in the wage leads to a 1% increase in output (or 1% decrease in the wage leads to a 1% decrease in output). Efficiency wage is the wage where elasticity of output with respect to the wage is exactly equal to 1. A profit-maximizing firm will choose this wage regardless of the market wage. 75

76 Efficiency Wages Efficiency wage must exceed the market wage or the firm will not be able to hire any workers. Because the efficiency wage is above the market wage it can cause an excess supply of labor. There will be more workers who want to work at the firm than the firm has jobs. 76

77 Efficiency Wages Similar idea is to pay workers who handle valuable objects or equipment or have lots of power a premium to keep them honest. 77

78 Incentive in Teams To achieve the full benefits of team production, rewards need to be based on team output. With team based performance measures, benefits from individuals actions are shared with the team. Some beneficial actions may not be undertaken. 78

79 Incentive in Teams If total benefit from action > total cost of action, it is a value creating action. Action will be undertaken only if total cost < (total benefit)/n (n= number of members in the team) Every team member lacks the incentive to take valuable actions (free rider problem). 79

80 Incentives in Teams Free rider problem is exacerbated if a team member has another task on which he works alone. Weaker incentives for team-based tasks will result in shift of effort to the individual-based task. 80

81 Evidence on Incentive in Teams In medical practices, increase in the size of partnerships lead to reductions in individual productivity. Larger law firms are less able to control costs compared with smaller firms. 81

82 Incentives in Teams Solutions Team size can be kept small. Team members can be made to cooperate by allowing them to work together for long periods. Teams can be structured so that team members can monitor each other. 82

83 Summary Agency problems occur when the actions of one person (the agent) can affect the wealth of a second person (the principle) and the principle cannot easily observe the actions of the agent. Two types of contracts: formal and implicit Formal contracts can be legally enforced. Difficult to enforce implicit contracts. Implicit contracts must be self-enforcing. 83

84 Summary Piece rates are used by firms when it is easy to observe the output of workers. Piece-rate compensation systems attract the most able workers and elicit high levels of effort from these workers. Workers being paid piece rates may stress quantity over quality, may not work with others in the firm, and may dislike fluctuating income. 84

85 Summary Some firms award promotions based on a relative ranking of workers. A tournament might be used when it is easier to observe the relative ranking of a worker than the absolute level of a worker s productivity Workers allocate more effort to producing output when the prize between winning and losing is larger 85

86 Summary Upward-sloping age-earnings profiles might arise because delaying worker compensation encourages workers to allocate more effort in the current period Some firms might want to pay wages above the competitive wage in order to motivate workers to work harder and produce more output Firms can motivate workers to work together by using team based performance measures 86