Transcript Lecture 9: The Structure of Compensation

Lecture 9
The Structure of Compensation
Another set of factors influencing job
choice and work effort decisions: employer
compensation policies both at one point in
time and over several period of time.
1. The Economics of Fringe enefits
1) Employee Preferences:
Two categories of benefits:
a) Payment in kind: compensation in the form of some
commodity, e.g., insurance, paid vacation.
Other things equal, people would rather receive $X
in cash than a commodity that costs $X. However,
‘other things” are not equal. In kind payments offer
employees a sizable tax advantage because for the
most part, they are not taxable under current income
tax regulations.
Deferred compensation: compensation that is
earned now but will be paid in the form of money
later on. E.g., pension benefits
Deferred compensation schemes enjoy a tax
advantage over current cash payments. Because of
lower income and special tax advantages given the
elderly, the tax rates actually paid are relatively low.
Note: With both kinds of benefits there is a loss of
discretion in spending one’s total compensation,
which tends to render fringes inferior to cash
payments in generating utility. On the other hand,
the special tax advantage of benefits as compared
with cash payments tend to increase the demand for
fringe.
b)
2) Employer Preferences
 Suppose employers are totally indifferent about
whether to spend $X on wages or $X on fringes,
then the composition of total compensation is a
matter of indifference to the employers, only the
level of compensation is of concern.
 Suppose a firm must pay its workers $X per years to
remain competitive in both the labor and the product
markets.
→The various compensation packages a firm is willing
to offer fall along the zero-profit isoprofit curve
drawn between wages and fringes.
Wage Rate
Employer’s Zero-Profit Isoprofit Curve
Nominal Employer Cost
of Fringe Benefits
The slope of the isoprofit curve is negative reflecting the fact that the
firm can increase fringes only if it reduces wages. In this case, the
isoprofit curve has a slope of –1, reflecting employer’s indifference
about the composition of compensation.
Note: By increasing compensation in the form of fringes rather than
wages, employers can often avoid taxes and required insurance
payments that are levied as a fraction of payroll. This will make it
more costly for an employer to increase compensation by increasing
salaries than by increasing benefits.
→A dollar spent on fringes could cost employers more or
less than a dollar nominally spent on wages or salaries.
When fringes enhance productivity more than a similar
expenditure on wages would, the isoprofit curve will
flatten. When fringes increase other costs or reduce
productivity, the isoprofit curve will be steeper.
Wage Rate
X
A
B
X
Nominal Employer Cost
of Fringe Benefits
3) The Joint Determination of Wages and Fringes
Wage Rate
X
Worker Y
WY
XX traces out the actual offers
made by all firms in this labor market.
Worker Z
WZ
FY
FZ
Nominal Employer Cost
X of Fringe Benefits
Those employees who attach relatively great importance to the
availability of current spendable cash will choose to accept offers in
which total compensation comes largely in the form of wages. (such
as worker Y) employees who may be less worried about current
cash income but more interested in the tax advantages of fringe
benefits will accept offers in which fringe benefits form a higher
proportion of total compensation. (worker Z)
Note: Because firms that pay high wages usually also
offer very good fringe benefits, it often appears to the
casual observer that wages and fringes are positively
related. Casual observation in this case is misleading
because it does not allow for the influences of other
factors, such as the demands of the job and the quality
of workers involved.
2. Current Status and Future Prospect of
Fringe Benefits
1) Current Status
There are three major types of benefits provided to
employees:
a) Paid: vacations, holidays, sick leave maternity leave
etc.
b) Insurance Plans: medical care, life, disability etc.
c) Retirement and Saving Plans: defined benefit
pension, profit sharing, employee stock
ownership etc.
d) Additional Benefits: parking, educational assistance,
employee discount etc.
2) Future Prospect
Over the past few decades there have been
considerable changes in the composition of
employee benefits offered to workers. While many
of these changes have brought a new philosophy,
and a new administration of employee benefits, all
indications point to a continual expansion and
redefinition of employee benefits packages. What
can we predict for the remainder of the 1990s?
a) Early Retirement
Early retirement programs are designed to assist an
organization in achieving some measure of cost
savings in their direct wage bill. Typically, as
employees’ tenure with an organization has grown
in years, these employees’ salaries have risen to
high levels. To address this concern, and realizing
that age discrimination laws may be affected an
incentive program to encourage these worker to
sever their ties with the organization.
→The key issue in early retirement programs is to
provide enough incentive for the employee to
voluntarily take an early retirement, while
simultaneously allowing for the direct wage bill of
the organization to be reduced.
b) Parental Leave
Parental leave can be defined as any leave from
work, paid or unpaid, for employees to attend to
child care responsibilities for a newborn infant or
newly adopted child.
→Although the Family and Medical Leave Bill
permits this time off, there is a financial concern:
The 9 to 5 organization estimates that fewer than 40
percent of working women would be financially
able to take an unpaid leave.
→There was an even greater controversy surrounding
parental leave-do fathers deserve the same time off
as mothers with respect to family leave? Under the
Family and Medical Leave Bill passed in 1993, they
do!
c) Children and Eldercare
Another major trend affecting corporations today is the push
for an increase in child- and elder-care benefits.
→Dual-career couples with children and/or elderly live-in
parents need to have some assurance that child- or eldercare
programs are available to them without major disruptions to
their lives.
→Companies are beginning to recognize that when its
employees are faced with a choice between their jobs and
their families, the vast majority of employees clearly place
their job second.
→American Express, IBM, Work Family Directions, and
Allstate Insurance have joined forces to offer quality
childcare at a facility that is in close proximity to all of their
employees. In coming years, we can only expect such
cooperative arrangements to continue when they are feasible
to both the employer and the employee.
d)
Flexible Benefits: A benefit program in which
employees are permitted to pick benefits that most
meet their needs, within monetary limits imposed.
1.
2.
3.
4.
Flexible Spending Accounts.
Modular Plans.
Core-plus Options Plans.
Add-on Plans.
3. The Compensation of Executives
There has been a lot of interest in recent years in the
salaries of high-level executives, such as chief
executive officers, or CEOs. American CEOs have
much higher salaries than their counterparts in
Germany and Japan. For example, the average salary
of the top 20 executives in the United States is $4.8
million, as compared to $1.8 million in Germany, and
$530,000 in Japan.
1) The Principal-Agent Problem

The analysis of CEO compensation also raises a number of
important questions in economics. In particular, what should
be the compensation package of a person who runs the firm,
yet does not own it?

The CEO is an agent for the owners of the firm (the owners
are also called the principals). The owners of the firm, who
are typically the shareholders, want the CEO to conduct the
firm’s business in a way that increases their wealth.

The inevitable conflict between the interests of the principals
and the interests of the agent is known as the principal-agent
problem. The structure of CEO compensation can be
interpreted in terms of a tournament where the vicepresidents compete for promotion, and where the winner
runs the company. This interpretation explains why the
“prize spread” is larger when executives are promoted to
CEO than when executives are promoted from junior to
middle-level management.

Suppose there are three levels of management: the
CEO, senior vice-presidents, and junior vicepresidents. Junior vice-presidents compete among
themselves for promotion to senior vice-president,
who in turn compete among themselves for
promotion to CEO. Executives who won the firstlevel tournament and were promoted to high-paying
jobs as senior vice-presidents may find that the
compensation in their current position “meets all their
needs,” and therefore may not want to compete for
promotion to CEO. In order to elicit work effort from
the senior vice-presidents, the prize associated with
becoming a CEO must be even larger than the prize
associated with becoming a senior vice-president.
2) The Link between CEO Compensation and Firm
Performance
 In order to continuously elicit the correct incentive
from the person who wins the tournament, the
CEO’s compensation will have to be tied to the
firm’s economic performance. The CEO would then
be restrained from taking actions which reduce
shareholder wealth. The empirical evidence
indicates that there is indeed a positive correlation
between firm performance and CEO compensation,
although the elasticity of CEO pay with respect to
the rate of return to shareholders is small.