Transcript CH. 11. PAY AND PRODUCTIVITY: WAGE DETERMINATION WITHIN

CH. 11. PAY AND PRODUCTIVITY:
WAGE DETERMINATION WITHIN THE FIRM
COMPENSATION ISSUES TO BE CONSIDERED.
• Using compensation to provide incentives.
• Efficiency wages.
• Deferred pay and/or bonds
• Types of Incentive Pay.
– Piece rate:
• Pay tied to amount of output produced.
• Examples: sales commissions; garment workers.
– Gainsharing:
• Pay tied to gains in measures of group “success”
(productivity, costs, quality, etc.)
– Profit-sharing or Bonus Plans: Pay tied to
profits of firm.
Piece Rates
• Employee preferences.
– Holding the “expected” level of pay constant,
employees prefer time-based over piece rate.
– Piece rate is “riskier”
• Production process is uncertain (e.g. Sales
commissions.)
– Piece rate will cause self-selection on
• productivity
• risk aversion
Piece Rates
• Employer preferences and piece rates.
– Advantages:
• Productivity is increased among a given work force.
• Attract most productive workers.
– Disadvantages:
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quantity vs. quality
willingness to help coworkers
treatment of equipment
cost of monitoring output
– sales: who made the sale?
– Is there a single “output” that can be measured?
• how to set a “competitive” rate.
– Negotiation costs
Empirical evidence on piece rates
• Lazear (2000):
• When glass installer switched from hourly to
piece rate,
• individual output of employees that stayed with the firm rose
20 percent.
• because the “slowest” employees left, average increase in
productivity was 36 percent.
• average pay of workers rose 9% (both employees and firm
benefitted).
Lazear, EP. “Performance Pay and Productivity.” American Economic Review,
v. 90 issue 5, 2000, p. 1346.
Empirical evidence on piece rates
• Jirjan & Stephan (2004)
– Women are more likely to be paid piece rates than
men
– Hypotheses:
• shorter expected tenure than men.
• greater demand for flexibility in work hours.
• Women prefer because subject to less wage discrimination
when objective performance measures are available.
– Authors conclude explanation is primarily the last
hypothesis.
Jirjahn and Stephan. “Gender, piece rates and wages: evidence from matched
employer–employee data.” Cambridge Journal of Economics, v. 28 issue 5, 2004,
p. 683.
Empirical evidence on piece rates
• Goldin (1986).
– Female manufacturing workers around 1900 were far more likely
than men to be paid by the piece
– Occupational segregation by sex and differences in earnings
result even if workers are equally productive.
– Feminization of clerical sector explained by improved ability to
monitor output with new office technology.
Goldin, C. “Monitoring Costs and Occupational Segregation by Sex: A Historical Analysis.”
JOURNAL OF LABOR ECONOMICS, v. 4 issue 1, 1986, p. 1.
Empirical evidence on piece rates
• Paarsch & Shearer (2000).
– Study of tree-planting firm
– Piece rate incentives caused 22 percent increase in
productivity.
– Improvements in productivity partly offset by
decreased quality.
Piece Rates, Fixed Wages, and Incentive Effects: Statistical Evidence from Payroll Records. Harry
J. Paarsch; Bruce Shearer International Economic Review, Vol. 41, No. 1. (Feb., 2000), pp. 59-92.
Group Incentive Plans
• Incentives for “group” performance
• Employee preferences:
– “free-rider” problem.
– risk sharing.
• Employer preferences:
– monitoring individual versus group output
– encourage team work
• Group incentives in a large firm
– free rider problem is amplified.
– can be used to persuade union to implement
productivity enhancing rules.
• Evidence of effect of profit sharing on productivity
is very mixed.
Examples of group incentives
• Tip pooling
– Waiters and waitresses
– Casino dealers
• Profit sharing plans
– Mixed evidence on whether the profit sharing
plans improve firm performance
• ESOP
Group Incentives at Continental Airlines
• Beginning in 1995, offered 35,000 eligible employees $65
in months in which Continental ranked 2nd or 3rd in on-time arrival
$100 when it finished first
Firm-Wide Incentives and Mutual Monitoring at Continental Airlines
M Knez, D Simester - Journal of Labor Economics, 2001
Group Incentives at Continental Airlines
The incentive scheme was self-funding.
• fewer Continental customers missed
connections and moved to other airlines
• additional cash flow of over $8 million per
month, yet the cost of the incentive scheme was
less than $3 million per month
• Effects on performance were greatest at “nonoutsourced” airports where employees were
eligible for bonus.
Merit Pay
• If costs of monitoring and risk aversion make piece rates
or group incentive plans undesirable, may choose to pay
on basis of time worked and reward based on “merit”.
• Still have problem with monitoring “output” and the
extent to which it is affected by “external forces”.
• Can remove effect of common external forces by using
– relative performance rankings
– executive pay and relative performance ratings.
– tournaments
• Problems with relative performance rankings:
– the incentive to “sabotage”.
– perceived “fairness” of ratings.
Efficiency Wages
• Increases in the level of pay may increase
productivity by:
– increasing the quality of worker that is hired.
– increasing the productivity of a given worker.
• reduces the probability of “shirking”
• can reduce monitoring costs.
• reduces turnover and saves on hiring/training costs.
• “efficiency wage premium”
– a premium above and beyond what a worker can earn
elsewhere that is justified by an increase in worker
productivity.
Efficiency Wages
• The trade-off between wages and monitoring
• q=per period probability that a worker is detected
shirking
• p=efficiency wage premium per period
• L=expected length of job
• Expected loss from shirking in a given
period=q*p*L
• A worker will shirk if expected gain from
shirking > q*p*L
Efficiency Wages
• To maintain a given level of output, a firm can trade-off between
more monitoring and a lower efficiency wage
– This yields an “isoquant curve”.
– Iso-quant curves further to the NE represent higher levels of
output since they are associated with a higher value of q*p*L).
$ on monitoring
Isoquant (q*p*L=constant)
$ on efficiency wages
Efficiency Wages
• If a firm spends $1 less on efficiency
wages, they can spend $1 more on
monitoring and keep the same cost.
• As more is spent on monitoring, the
probability of detection rises. This yields
an “iso-cost curve”.
Efficiency Wages
• Iso-cost curves further to the SW are lower levels of
costs
$ on monitoring
Slope = -1
Iso-cost
$ on efficiency wages
Efficiency Wages
$ on monitoring
Isoquant
$ on efficiency wages
A steeper isoquant
emerges if monitoring is more costly
leads to more efficiency wages and less monitoring
Firm will have more of both efficiency wage and monitoring if
costs of shirking are especially high to firm.
Efficiency Wages
Factors influencing combination of efficiency wages
and monitoring
• advancements in technology for monitoring
•changes in expected length of job.
• increase in cost of shirking
• Capital intensity
• Reputation
• Employment at will laws (cost of discharge)
• Firm size
Empirical studies
• Raff and Summers (1989)
– Did Henry Ford Pay Efficiency Wages?
– Introduction of the five-dollar day in 1914
– strongly supportive of the relevance of
efficiency wage theory.
• evidence that the five-dollar day resulted in
substantial queues for Ford jobs.
• significant increases in productivity and profits at
Ford accompanied the introduction of the fivedollar day.
Efficiency wages
• Cappelli (1991).
– Comparison of workers across plants of a
single firm.
– Plants with higher wages had fewer
disciplinary dismissals
– Disciplinary dismissals also drop when cost of
dismissal rises (poor job alternatives).
Cappelli (1991). “An Interplant Test of the Efficiency Wage Hypothesis.”
The Quarterly Journal of Economics, v. 106 issue 3, 1991, p. 769
Deferred Pay
Deferred pay may increase lifetime productivity by:
• reducing quits (selection effects enhance this)
• reducing monitoring costs
Necessary conditions for deferred pay:
• PV of lifetime compensation must be at least
equal to that in alternative jobs.
• “underpayment” followed by “overpayment”
relative to MRP.
Deferred Pay
Risks to employee
• firm has an incentive to fire once wage exceeds
MRP.
• reputation effects may prevent firm from
violating implicit agreement.
•age discrimination laws may also prevent firm
from violating agreement.
Deferred Pay
Risks to employer
• worker may want to postpone retirement
beyond “implicit” agreement.
• firm may respond with “mandatory retirement”
(no longer legal).
• firm may respond with pension that encourages
retirement (DB plan, not DC).
Deferred Pay vs. Efficiency Wages
• Both can be used to reduce shirking and turnover.
• Deferred pay is “cheaper” because PV of pay is
same as best alternative, whereas efficiency wage
pays more than best alternative.
• Drawbacks to deferred pay are listed above (risks
to employee)
• Efficiency wage stories have been used to justify
trade protection, affirmative action, minimum wages,
wrongful discharge legislation, and a wide range of
other government policies.
Deferred Pay vs. Efficiency Wages
• Efficiency
wages may lead to employer
discrimination against
•Elderly
•Women
•Deferred pay
• May require legal intervention by government to
make contract credible.
• employment law regarding wrongful
discharge
• ERISA
Tournament Theory
• Suppose that employees produce output
according to
Qi= a*ei + ui + v
ei = person i’s effort
ui = random error affecting person i’s output
v = random error affecting all workers’ output
e,u and v are unobservable to employer.
Tournament theory
• How should firm compensate worker?
– Pay according to Q?
• Pro: encourages effort by employee
• Con: risk averse workers will avoid; must pay risk
premium. More costly as variance of e and u
increases.
– Pay by time and attempt to monitor output
• Pro: no risk premium
• Con:
– costly to monitor if variance of e or u is high;
– Incentive to provide effort is reduced.
Tournament theory
• Pay according to relative performance
– Eliminates risk in pay due to common shocks
(v)
– Most beneficial when Var(v) is large, Var(u)
small.
• Possible problems
– If different ability among workers, low level
workers may
• Follow risky strategies
• Not put forth effort if no chance of winning
• Hybrid schemes: tournament plus time pay.
Tournament Theory
Knoeber and Thurman:
• use data on broiler producers facing both
tournament and linear performance evaluation
compensation structures to test three predictions
• In mixed tournaments, more able players will
choose less risky strategies
• tournament organizers handicap players to avoid
the disincentive effects of mixed tournaments..
Testing the Theory of Tournaments: An Empirical Analysis of Broiler
Production. Charles R. Knoeber; Walter N. Thurman
Journal of Labor Economics, Vol. 12, No. 2. (Apr., 1994), pp. 155-179.