Chapter 5: Variable pay or straight salary University Professors get a straight salary which is not even based on age (may be considered high or low, depending on your point of view). Should we introduce incentive pay, e.g. by # of exams or scientific papers written? What are the tasks of academics? What are problems of incentive pay? 1
Some issues... Should pay be based on input or output? How can output be defined? Does paying for output cause workers to seek the wrong goals? Does output-based compensation induce people to focus on the short-run only? 2
Variable pay or straight salary Pay by Output = Incentive Pay Agricultural workers (piece rate) Salespeople (straight commission) Top executives (stocks as part of compensation) Pay by Input Depends on effort spent on an activity, time = proxy for input, effort 3
Effects of incentive pay 1. Selection: good workers stay, bad workers leave 2. Incentives: workers put more effort into work 4
1. Selection Positive influence on hiring and retention low ability workers will look for jobs that pay by input rather than output workers who do not want to work hard are likely to leave the firm. Weekly Pay 500 5 $100/sale Flat rate=$500/week Number of encyclopedias sold If you can sell > 5, you go to the company with output based pay. If < 5 you go to the flat base pay 5
2. Incentives How to set an optimal incentive scheme? Example: taxi drivers Scheme A: Driver rents the car, pays for gas and keeps all revenues (commission rate = 100%) e.g. compensation = - $100 + $ 2*(miles driven) gasoline expense Scheme B: Company provides driver with the cab, pays for gas and they split the revenues 50:50 ( revenue splitting ) 6
Problems with Scheme B Moral hazard of driver switch off meter (monitoring difficult!) Suboptimal effort goes home too early Compensation Scheme A Adverse selection Here also: only less able or less hard-working are attracted - 100 Q* Output Scheme B 7
Deriving the optimal compensation scheme Assumptions: Output of worker depends only on effort E Worker is averse to effort E, Goal: Disutility of effort E is C(E) How to set an optimal compensation scheme α +βe that maximizes firm s profits? 8
The worker s considerations How does the worker choose effort optimally to max her utility: Max α+βe C(E) E where α+βe is the worker s total compensation First order condition: =β C'(E) = 0 E β= C'(E) put so much effort into work until marginal effort cost equals the marginal return for effort 9
How does the firm choose wage schedule: α and β? Firm chooses α and β to maximize profits, but has two constraints: Choice of β will determine Effort E (previous slide) Total compensation must be high enough to keep the * * worker with the firm, i.e. α+βe C(E ) Net revenue is defined as E, firm maximizes: Max E - α - βe = E - C(E) β First order condition: E ( 1 C'(E) ) = 0 1 = C'(E) = β β 10
Surprising result: worker should get the whole additional output! β = 1: Worker should act as residual claimant should act like an entrepreneur. Only this contract will allow the optimal choice of effort! How does the firm make profit in this case? chooses α as low as possible, but so that worker is still willing to sign the contract! Select α so that: * * α+ E = C(E ) 11
Example: salesperson s commission Marginal costs for computer $900 Market price $1000 What is the optimal commission per piece? As a percentage of sales? Solution seems optimal for the worker, but is this really optimal for the firm? 12
Example: salesperson s commission Profit for the firms comes from rental fee of the job (desk) Again: Why not simply lower commission rate? Input of effort would be inefficient, total output inefficiently small! 13
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The reality-question! Principle idea: 100% commission rate, and worker has to pay for having the job. Why don t you often see workers paying for their jobs? Often no explicit payment, but implicit 16
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Paying for the job Is it better to have, say, 10% in sales or 100% in profits? Moral hazard on the side of the firm! Consider the 100 percent commission of the taxi driver. Does this scheme solve all incentive problems? Capital market imperfections do not allow buying the firm, which would sometimes be the best solution to maintenance problems. 18
Advantages of time-based pay Cost advantage in measurement Quantity versus Quality How can quality checks be done? Quality more difficult to measure Use random sample 19
Disadvantage of piece rate: Sometimes output does not only depend on effort causes risk for worker! Sometimes variations in output are beyond the worker s control (economic downturn etc.) Payment by output: worker suffers from economic downturns, benefits from boom. Here: Output Q=E+ε, with ε as a random variable Wage schedule: W = α + βq = α + β(e+ε) 20
Risk aversion of workers Usually workers are risk averse, their liabilities (food, housing, clothing etc.) are relatively fixed, variations in income generate difficulties. Firms are usually more risk neutral, can diversify risk across investments. 1 st principle of optimal insurance: the party who can more easily absorb risk (i.e. the party that is most risk neutral) should insure the other party. If the firm accepts to bear the risk it can pay lower wages. Trade-off: insurance reduces worker s incentives! 21
Size of incentives setting β when β = 1 not possible (risk aversion) The lower the risk aversion among workers, the higher the incentives should be. The higher the ability of workers, the stronger the incentives should be. The stronger the effect of increased effort by the employee on company profits, the greater the incentives should be. The stronger the impact of incentive on effort, the greater the incentives should be. The greater the precision of output measurement, the greater the incentives should be. 22
Measurement of output Sometimes output is of a kind that is simply unmeasurable. If variations in output are due to external factors that are not controllable by the employee it is difficult to measure effort. If the work of the employee depends upon coordination with other employees, it may be difficult to single out their individual contribution. It may be necessary to pay on a team basis. There may be multiple tasks. Incentives must be balanced across different tasks. If it is difficult to measure the performance on task A, strong incentives on other tasks will result in the employee ignoring task A. 23
Equal Compensation Principle If the worker has two tasks, either compensate effort alike in both, or don t use incentive contracts E.g. University professors do teaching and research Similar problems: Quantity versus quality Short run and long run incentives 24
Difficulties when setting a piece rate Management has the incentive to increase the required level of production when the workers easily surpass their old levels. This is called the ratchet effect. Workers earn profit for extra effort only for one period, in the next the gains are taken away by the firm. Since workers realize that the ratchet effect exists, they will be reluctant to work to their full capacities in the first period or they may try to force other workers to slow down. (Interests of stayers versus leavers.) ==> make long-term contracts with commitment not to change piece rate schedule 25
Different types of payperformance payment Output based measures often involve quotas, bonus payments, caps or promotions. What are the advantages, disadvantages of these schemes? 26
Chapter 13: Application: Safelite Glass Largest installer of automobile glass in US Until 1994 glass installers were paid hourly wage rate Then shift to piece-rate schedule, pay per number of glass units installed Computerized information system: no measurement costs 27
Indifference curves of workers Individual is indifferent to putting more effort into work if sufficiently compensated Upward sloping because output requires effort which is painful ( bad ) Utility increases to the northwest Convex because for greater levels of efforts worker demands even larger compensation for increased effort (closer to exhaustion) 28
Two types of workers Type A doesn t like to work: He has to be paid a lot so he is prepared to put in additional effort. Type B doesn t have such a strong distaste against work. For a little compensation she is willing to work harder. 29
Choice of effort by workers straight salary If workers are paid by time and the minimum acceptable standard of effort is e 0, than both types of workers will choose an effort of exactly e 0. But: some workers might actually be willing to work significantly harder for only slightly higher pay! 30
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Predictions of theory when switching to piece rates Switching to piece rates...... leaves some individuals behavior (those less able/less motivated) unaltered. These are equally well of as before.... increases the effort of others (those more able/more motivated). Thus, average effort rises. Satisfaction of this group also rises. Since higher ability workers now find the firm relatively more attractive, average ability rises. 34
Empirical findings at Safelite Glass Corporation Switch from salaries to piece rates induced a 36% increase in productivity. 2 Effects: Effort Effect: 20 % due to incentives: Given worker produces 20 % more after switch to piecework. Sorting Effect: 16 % are due to changing composition of the workforce: more high-quality types attracted Pay increased by 9% (Based on Lazear, E.P., Performance pay and productivity, American Economic Review, 2000, 1346-1361) 35
Safelite Glass Corporation: Some additional remarks Quality problems: Replacement of broken or leaking windshilds by installer on own time Measurement: Computerized Competition: Other firms will copy switching to piecework if profitable. But in the meantime Safelite Glass Corporation can make higher profits. 36
Bonuses or penalties Consider 2 different job offers: Scheme A pays $10,000 per month plus a bonus of $1 for every unit sold Scheme B pays $15,000 per month with a 5,000 unit quota: penalizing the worker with $1 for every unit below the quota To make it simple: suppose it s not possible to produce more than 5,000. What is more attractive for workers? Which job offer creates the highest incentives? 37
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Bonuses or penalties Psychological considerations: only use positive rewards Theory of loss aversion (Kahneman and Tversky): experiments showing that people hate to give up somethingtheyfeeltheyown. Economic considerations: Use bonus when there is no cost to poor performance Use penalty if there is no benefit to high performance Examples? 39
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