Transcript Contemporary Labor Economics

Chapter 7
Alternative Pay Schemes and
Labor Efficiency
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
1. Economics of Fringe
Benefits
7-2
Fringe Benefits as a
Proportion of Compensation
7-3
Relative Growth of Fringe
Benefits
7-4
Occupation & Industry
Differences
o Fringes greater in
• High-paying industries vs. Low-paying
industries
• Goods-producing industries vs. Services
• Transport & Utilities vs. Retail Trade
o Fringes greater in Blue-Collar than WhiteCollar occupations
o Fringes greater in Union vs. Non-Union
jobs
7-5
2. Theory of Optimal
Fringe Benefits
Why have fringes grown and is it
desirable?
7-6
Worker Indifference Map
• The indifference curves show
the combinations of wages and Wages
fringe benefits that yield the
same amount of total utility.
• Fringes benefits are
somewhat substitutable for
wages even though most fringe
benefits are in-kind benefits
(benefits for a specific good or
service).
• Workers substitute wages for
fringe benefits because wages
are taxed, but fringe benefits
are not.
• They also may substitute
wages for fringe benefits to
insure money is available for
health insurance and
retirement.
I1
I2
I3
Fringe Benefits
7-7
Employer’s Isoprofit Curve
• An isoprofit curve (WF) shows
the combinations of wages and
fringe benefits that yield the
same amount of profits.
• We assume that competition
will yield a normal profit.
• This curve shows the
combinations of wages and
fringes the firm can afford to
provide, given the “prices” of
wages and fringe benefits.
Wages
W
F
Fringe Benefits
7-8
Wage-Fringe Optimum
• The optimal combination of
wages and fringe benefits is at
B, where the isoprofit curve is
tangent to the highest attainable
indifference curve (I2).
• Here the firm will provide W0
wages and F0 fringe benefits.
Wages
W
A
• Points A and C are also
attainable combinations of
wages and fringe benefits, but
they yield less total utility
since they are on a lower
indifference curve (I1).
W0
B
I3
I2
C I1
F0
F
Fringe
Benefits
7-9
Fringe Benefit Growth
• A decrease in the price of
fringe benefits due to tax
advantages, scale economies,
and efficiency considerations
fans the normal isoprofit line
outward.
• This allows the worker to
attain a higher indifference
curve (I2 rather than I1).
Wages
W
W0
W1
A
B
• In the process, fringe
benefits expand from F0 to F1.
I1
F0
F1
F
I2
F’
Fringe
Benefits
7-10
Causes of Fringe Benefit
Growth
o Advantages to employees
• Fringe benefits reduce the taxes the
employees pay.
∞Employer pension contributions tax
deferred
∞Retiree tax rates likely to be lower
∞Health contributions tax exempt
• Health insurance cheaper at group
rates.
• Fringes are normal goods so demand
increases as incomes rise
7-11
Advantages to Employers
o Tax advantages to employers
• Fringe benefits reduce the taxes the
employers pay.
∞Employers pay half of the Social Security tax.
∞If employers substitute fringe benefits for wages,
their taxes will be reduced.
• The Social Security tax rate and base have
increased over time.
∞This rotated out the isoprofit curve and increased
fringe benefits.
7-12
o Economies of scale
• The are significant scale
economies in the provision of
fringe benefits.
• Firms have grown in size over
time and lowered the per unit
cost of fringe benefits.
∞This rotated out the isoprofit curve
and increased fringe benefits.
7-13
o Efficiency considerations
• Employers prefer to have lower
turnover to protect their training
investments and reduce recruiting
costs.
∞Fringe benefits such as pensions and
health care reduce worker turnover.
• Over time, training by firms has
increased and so firms have had
increased incentive to use fringe
benefits to reduce turnover.
7-14
Question for Thought
1. The U.S. Office of Management and Budget has
estimated that the tax-exempt status of fringe
benefits such as pensions and group insurance
reduces tax revenue to the U.S. Treasury by $350
billion annually. Some economists have
suggested that the federal government recover
this tax revenue by taxing fringe benefits as
ordinary income. Use a diagram to explain how
this proposal would affect (a) the slope of
indifference curves and (b) the slope of the
isoprofit curve. What would be the likely effect
on the optimal level of fringe benefits?
7-15
3. Principal-Agent
Problem
How can firms structure pay to
ensure performance?
7-16
Principal-Agent Problem
o The principal-agent problem occurs
when agents (workers) pursue some of
their own objectives which are in conflict
with the goals of the principals (firms).
• Workers can increase their leisure by
shirking (working slowly or taking
unapproved breaks) on the job.
∞The profits of the firm will be lowered.
o Firms have a profit incentive to reduce
principal-agent problems.
7-17
4. Pay for Performance
o Piece Rates
o Commissions
o Hourly Wages vs. Salary
o Bonuses
o Profit Sharing
o Tournament Pay
7-18
Piece Rates
o Piece rates are compensation paid in
proportion to the number of units of output.
• Piece rates limit the amount of shirking.
o Drawbacks
• May be difficult to set rate as APL changes.
• They increase income variability and so firms
will have to pay a premium.
• Difficult to use where team production is key:
who made what & decreased cooperation
• Workers may decrease quality.
7-19
Commissions
and Royalties
o Unlike piece rates, commissions
and royalties are compensation
paid in proportion to the value of
sales.
• These are efficient where work
effort is difficult to observe but job
performance tied to sales
∞Authors, sales people, recording
artists
7-20
Hourly Wage vs. Salary
• If a worker is paid by the hour,
the worker will choose point A
with an annual income equal to
Y1with L1 hours of leisure.
• An equivalent annual salary
of Y1, the worker can get to a
higher indifference curve I2 by
increasing hours of leisure to L2.
• The worker can get this
higher level of utility by
shirking.
• The firm can overcome this
incentive problem by offering
future raises or promotions to
those who consume L1 hours or
less of leisure.
Annual Income
I2
I1
W
A
Y1
0
L1
B
L2
L
Leisure
7-21
Bonuses
o Bonuses are payments beyond the annual
salary based on some factor such as
personal or firm performance.
• Elicit extra work effort and are not permanent
costs.
o Personal performance bonuses
• Based on evaluation by superiors or
quantifiable measure.
• May have unintended effects.
∞Workers schmooze superiors.
∞Workers work to bonus items, nothing else
7-22
Bonuses
o Team performance bonuses
• Based on team performance.
• Leads to the free-rider problem.
∞ Workers have less incentive to work
hard as the size of the group rises since
their own effort matters less.
• Team performance bonuses work
best when the size of the group is
small.
7-23
Profit Sharing
o Profit sharing is a pay system that
allocates a portion of the firm’s profits to
its employees.
• In 2008, 11.2 million workers were in a
profit sharing plan.
• Supporters argue that profit sharing gives
workers the incentive to work harder to
increase firm profits.
• Critics argue that it suffers from the freerider problem.
• Evidence indicates a modest positive effect
on productivity.
7-24
Tournament Pay
o Tournament pay plans base compensation
on relative performance.
• A large prize exists for top performer, smaller
prize for second place, and so on.
• Encourages all participants to exert more
effort.
o The CEO position may be first place in a
tournament.
• CEO’s are usually paid more than their
personal MRP, but other executives increase
their MRP in hopes of getting the top prize.
7-25
Highest Paid CEOs, 2007
Name
Company
Lawrence J Ellison
Oracle
Total Pay
(millions)
192.9
Frederic M Poses
Trane
Aubrey K McClendon Chesapeake Energy
Angelo R Mozilo
Countrywide Financial
127.1
116.9
102.8
Howard D Schultz
Nabeel Gareeb
Daniel P Amos
Lloyd C Blankfein
Richard D Fairbank
Bob R Simpson
98.6
79.6
75.2
73.7
73.2
72.3
Starbucks
MEMC Electronic Mats
Aflac
Goldman Sachs Group
Capital One Financial
XTO Energy
7-26
Tournament Pay and CEOs
o Implications
• Managers who don’t quite make it to CEO
will also be paid more than their MRP.
• “Golden parachute” provisions in executive
contracts provide protection against losing
the full amount of CEO prize in takeover.
• Tenure in CEO position is short because
firms need to provide openings for others.
7-27
Tournament Pay and CEOs
o Criticisms
• May not be optimal since participants may
sabotage another’s performance.
• Pay may be excessive because executives
determine the pay of other executives by
serving on the corporate boards of other
firms, i.e., “mutual admiration societies.”
7-28
5. Efficiency Wage
Payments
7-29
Efficiency Wage Payments
o Firms may reduce shirking by
monitoring the efforts of workers.
o Monitoring workers is costly in
some cases.
• Babysitters, security guards,
managers
o One solution is to pay an abovemarket wage.
7-30
Wage-Productivity Dependency
o A higher wage may increase worker
productivity by:
• Increasing employee work effort
• Improving worker capabilities
• Increasing the proportion of skilled workers in the
workforce
o An efficiency wage is one that minimizes an
employer’s wage cost per effective unit of
labor employed.
• The marginal benefit of a higher wage equals the
marginal cost of the higher wage.
7-31
Efficiency Wage Theories
o Shirking model
• Paying an above-market wage will increase the
relative wage of the job.
∞This raises the opportunity cost of being terminated
for shirking.
∞Workers increase their effort (productivity) in
response to this higher opportunity cost.
o Labor turnover model
• Firms increase wage to reduce turnover.
∞The lower turnover increases productivity since
more experienced workers don’t quit as often.
7-32
Non-Clearing Markets
• Suppose a firm finds it can
lower its effective cost per unit
of labor by increasing the wage
rate from W1 to W2.
• The lower cost is the result of
increased productivity of the
workers. This reflected in a
rightward shift in the labor
demand curve from D1 to D2.
S
Wage rate
W2
B
W1
C
A
• Though W2 is an equilibrium
wage, it results in a labor
surplus of BC and is not the
market clearing wage.
• The unemployment of BC
workers generates part of the
productivity gain since the
threat of unemployment
encourages workers not to
shirk.
D2
D1
Q1
Q
2
Quantity of
Labor Hours
7-33
Criticisms
o Alternatives to efficiency wages exist
such as piece rates and
commissions.
o Workers could post a bond they
would forfeit if they were found
negligent.
o Employers could reduce shirking by
deferring part of worker’s pay.
7-34
Questions for Thought
1. Speculate on what actions workers might take
to resolve a free-rider problem.
2. People often sell goods (or raffle tickets) as part
of a fundraising project. These projects typically
offer valuable prizes to those who sell over a
fixed number of units. Often a grand prize, say, a
trip to Hawaii is offered to the person who sells
the most units. Why are these prizes offered?
Relate this example to the high pay received by
chief executive officers of large corporations.
7-35
6. Deferred Payment
Schemes
7-36
• In the diagram is MRP
constant over the person’s
worklife.
• Firms and workers may enter
into implicit contracts that
increase pay as years of service
rise.
• Younger workers receive pay
that is less than their MRP,
while older workers are paid
more than their MRP.
• The prospect of high pay at
the end of one’s career may
discourage shirking and reduce
turnover.
• Because of the increased
productivity, workers may get
higher lifetime earnings than if
wages equaled MRP each year.
Wage rate, MRP
Deferred Pay Contracts
Wage
MRP
Quantity of
Labor Hours
7-37
Role of Pensions
o With deferred pay contracts, workers may
not want to retire at the normal age due to
their high pay.
• This is not optimal for firms since the worker’s
pay is greater than their MRP.
o Pensions solve this problem by providing
generous benefits if workers retire in certain
age ranges.
• Pension also raise MRP by reducing turnover.
∞Benefits are much higher for those with high tenure.
7-38
Final Points
o Deferred pay contracts are most likely
in large established firms.
• Workers may be more difficult to monitor
in large firms.
• Large firms are less likely to go bankrupt
and so younger workers are more willing
to have a deferred pay contract.
• Large firms are less likely to cheat on a
deferred pay contract by firing older
workers.
7-39
COLAs and Seniority
o Standard economic theory asserts that
wages and employment are tied to
individual productivity
o Most workers, however, get annual COLA
adjustments and have seniority rights
because of principal-agent problem
o Firms need workers to train new workers
because most skills are OJT
7-40
COLAs and Seniority
o Seniority based pay & employment rights
• Maximizes transmittal of knowledge between
existing employees
• Minimizes resistance to new knowledge and
processes
• Minimizes resistance to the hiring of new
productive workers
o Merit-based pay and employment rights
would create principal-agent problems
7-41
Case: Tenure for Faculty
o Historically tenure is designed to ensure
academic freedom = ability to explore and
express unpopular positions
o Criticized as diminishing work effort and
departmental productivity (best young
profs slotted to principles classes)
o Some have argued political power of
faculty with colleges has preserved it.
7-42
Case: Tenure for Faculty
o Tenure can be viewed as a cure for a
serious Principal – Agent problem
• Existing faculty choose new faculty
• w/o tenure, would recommend the weakest
• w/tenure, senior faculty willingly participate in
search for best new faculty
• Tenure aligns interests of senior faculty and
administration
• Tenure problems are addressed with buyouts,
generous retirement benefits.
7-43