Chapter 12. Incentive Pay. Introduction

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1 Chapter Incentive Pay 12-2 Introduction The chapter analyses how and why different methods of compensation arise in the labour market and how they affect worker productivity and firm profitablility. For example: - Piece rates and time rates. - Tournaments (to rank workers in a firm according to their productivity). To the winner go the spoils Policy application: The compensation of executives - Delayed compensation: Upward sloping age-earnings profiles discourage workers from shirking. - Efficiency wages. Only the material in the section on efficiency wages (Section 12.5) is compulsary. Other sections should be of interest if you intend to join the workforce! Read them at your leisure. 1

2 12-3 Tournaments Some firms award promotions on the basis of the relative ranking of the workers. A tournament, or contest, might be used when it is cheaper to observe the relative ranking of a worker than the absolute level of the worker s productivity. Workers allocate more effort to the firm when the prize spread between winners and losers in the tournament is very large. Disadvantages of tournaments with a large prize spread are the inherent incentives for corruption (e.g. in sport) and too much competition between participants (students/workers/managers) (e.g. students stealing or hiding library books required for an exam; in general, sabotaging work of fellow workers). Figure 12.3: The Allocation of Effort in a Tournament 12-4 Dollars X Y MC A MR HIGH MR LOW Effort The marginal cost curve gives the pain of allocating an additional unit of effort to a tournament. If the prize spread between first and second place is large, the marginal revenue to an additional unit of effort is very high (MRHIGH) and the worker allocates a lot of effort to the tournament. F low F high 2

3 Policy Application: Compensation of CEOs determined by Tournament 12-5 What should be the compensation package for a person who runs a firm, yet does not own it? The principal-agent problem: The conflict of interest between a firm s owners (the principals) and the manager/ceo (the agent). There seems to be a positive correlation between firm performance and CEO compensation, but the correlation is weak. - It is unlikely, therefore, that CEOs have the right incentives to take only those actions that benefit the owners of the firm. Work Incentives and Delayed Compensation 12-6 Upward-sloping age-earnings profiles might arise because delaying the compensation of workers until later in the life cycle encourages them to allocate more effort to the firm, i.e. they prevent shirking. A delayed-compensation contract also implies that at some point in the future the contract must be terminated (because in later years the firm pays the worker a wage greater than his/her value of marginal product), thus explaining the existence of mandatory retirement in many labour markets. - Even if no mandatory retirement age, the structure of pension plans might encourage workers to retire at a particular age. 3

4 12-7 Figure 12.4: The Worker is Indifferent Between a Constant Wage and an Upward-Sloping Age-Earnings Profile Earnings D A B 0 t * N C VMP Years on the Job If the firm could monitor a worker easily, she would get paid her constant value of marginal product (VMP) over the life cycle. If it is difficult to monitor output, workers will shirk. An upward-sloping age-earnings profile (such as AC) discourages workers from shirking. Workers get paid less than their value of marginal product during the first few years on the job, and this loan is repaid in later years Efficiency Wages Some firms might want to pay wages above the market-clearing competitive wage in order to motivate the work force to be more productive. Some possible reasons for efficiency wages: - In the context of poor countries, higher wages lead to better nutrition resulting in higher productivity. - Pay workers higher wages so that they have something to loose if they do not perform and get fired. ( shirking models ) - Pay higher wages to attract higher ability workers, i.e. raise the average quality of job applicants. Such workers are likely to have higher reservation wages. - Higher wages increase loyalty etc. Workers perform better if they perceive their wages as fair. ( fairness models, gift exchange models ) - Higher wages can reduce quit rates (i.e. turnover), thereby reducing recruitment and training costs. ( labour turnover models ) - Pay higher wages to bribe workers not to join a union. 4

5 12-9 Efficiency Wages ctd. Efficiency wage: The wage where the marginal cost of increasing the wage (above the competitive wage level) exactly equals the marginal gain in the productivity of the firm s workers. Rule that determines the profit-maximising efficiency wage w e : - The efficiency wage is set such that the elasticity of output with respect to the wage is equal to 1. This rule can be derived graphically (Figure 12.5) and algebraically. Students should understand both derivations. - Slope of straight line = q/w. Equal to average product of a $ paid to workers. Firm wants to achieve the highest q/w ratio possible. - Slope of total product curve (i.e. marginal product) = q/ w. - Highest q/w ratio possible where the two curves are tangent, i.e. have same slope: q/ w = q/w The wage that fulfills this condition is w e! Re-write as: ( q/ w) w/q = % q / % w = 1 Figure 12.5: The Determination of the Efficiency Wage Output q e q Y 0 w X w e Z Total Product Curve Wage The total product curve indicates how the firm s output depends on the wage the firm pays its workers. The curve embodies the wage-effort relationship. It is drawn for a given level of employment. The efficiency wage is given by point X, where the marginal product of the wage (the slope of the total product curve) equals the average product of the wage (the slope of the line from the origin). The efficiency wage maximises the firm s profits. 5

6 12-11 Efficiency Wages ctd. A profit-maximising firm will set w e regardless of the value of the competitive wage determined outside the firm! Because w e is greater than the competitive wage, it creates a pool of workers who are involuntarily unemployed. Different firms have different effort and production functions. Therefore, they may have different efficiency wages. Evidence on efficiency wages: - Classic example: Henry Ford, Quite a lot of fairly recent supporting evidence (p. 476/7). Permanent wage differentials exist across firms etc. Footnote 38: Krueger s (1991) fast food industry study. Also see Footnote Interindustry Wage Differentials Efficiency wage theory is one possible explanation for the observed interindustry wage differentials that exist among comparable workers. - See Table Interindustry (II) wage differentials are observed for many countries, rich and poor, and they tend to be very persistent over time! - The competitive model would suggest that the II wage differentials reflect differences in job characteristics and unobserved worker traits. - Efficiency wage theory would suggest that the II wage differentials are NOT due to job & worker characteristics. They arise because in some industries firms find it profitable to pay higher wages, firms in other industries do not. 6

7 12-13 Interindustry Wage Differentials ctd. Does the competitive model or the efficiency wage model apply? Mixed and confusing empirical evidence (p. 479)! - II wage differentials DO persist after controlling for job & worker characteristics. - But: Workers also DO sort themselves across industries. - In short, BOTH types of explanations seem to apply, but how much of the II wage differentials does each explain? Some NZ evidence on raw II wage differentials (i.e. looking at average industry wages without accounting for job & worker characteristics). Efficiency Wages and Dual Labour Markets The efficiency wage hypothesis generates an economy with dual or segmented labour markets: - Primary sector (worker s output hard to observe and monitoring is costly, e.g. knowledge workers ) pays high efficiency wages. High wage industries, Good jobs (also includes good working conditions, employment stability, chances for promotion). - Secondary sector (workers perform repetitive and monotonous taks, output can easily be measured) pays low competitive wages. Low wage industries, Bad jobs (dead-end jobs). With competitive labour markets, the wage differences between primary and secondary sectors would disappear over time (workers would move from low to high wage sector). With efficiency wages, the wage differences persist. 7

8 12-15 The Bonding Critique The bonding critique is a criticism of the key assumption of the efficiency wage model that there are permanent wage differentials across firms. The bonding critique suggests that such wage differentials self-destruct in the long-run because workers who want jobs in the primary sector will be willing to pay employers for the right to be employed in that sector, e.g. by posting a bond at the time of getting hired. More realistically, workers might at first accept wages below their value of marginal product (a delayed compensation scheme). This would tilt upwards the age-earnings profile in high wage industries. - Still an open question to what extent the bonding critique applies End of Chapter 12 8

Lecture 10 Pay and Productivity

Lecture 10 Pay and Productivity 1 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