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Chapter 12

Labor MarketContracts and Work

Incentives

Copyright 2008 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

Labor Economics, 4 th edition

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Pay Systems: Piece Rates

Piece rates are used by firms when it is cheap to monitor theoutput of the workers.

Piece-rate compensation systems attract the most able workersand elicit high levels of effort from these workers.

Workers in these firms, however, may stress quantity overquality, and may dislike the possibility that incomes fluctuatesignificantly over time.

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The Allocation of Effort by Piece-RateWorkers

Dollars

q*

r

OutputqABLE

MR

MC MC ABLE

The piece rate is r dollars, so themarginal revenue of an additional unitof output equals r . The worker gets

disutility from producing output, asindicated by the upward-slopingmarginal cost of effort curve. Thelevel of effort chosen by a piece-rateworker equates marginal revenue tomarginal cost, or q* units. If it iseasier for more-able workers toallocate effort to their jobs, they facelower marginal cost curves and

produce more output.

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Pay Systems: Time Rates

Time rates are used by firms when it is costly or impossible tomonitor the output of workers

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Effort and Ability of Workers in Piece-Rate and Time-Rate Jobs

Utility

r

Ability

Piece-RateWorkers

Time-RateWorkers

Worker BWorker A x*

All workers, regardless of theirabilities, allocate the sameminimal level of effort to time-rate

jobs. Because more-able workersfind it easier to allocate effort,they will allocate more effort to

piece-rate jobs and will havehigher earnings and utility.

Workers with more than x* unitsof ability sort themselves into

piece-rate jobs, and less-ableworkers choose time-rate jobs.

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Tournaments

Some firms award promotions on the basis of the relativeranking of the workers.

A tournament might be used when it is cheaper to observe therelative ranking of a worker than the absolute level of theworkers productivity.

Workers allocate more effort to the firm when the prize spread between winners and losers in the tournament is very large. Alarge prize spread, however, also creates incentives for workersto sabotage the efforts of other players.

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The Allocation of Effort in aTournament

Dollars

Effort

MC A

MRHIGH Y

X MRLOW

F high F low

The marginal cost curve givesthe pain of allocating anadditional unit of effort to atournament. If the prize spread

between first and second placeis large, the marginal revenueto an additional unit of effort is

very high ( MRHIGH) and theworker allocates a lot of effortto the tournament.

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Policy Application: Compensation ofCEOs

There is a positive correlation between the compensation ofCEOs and the performance of the firm, but the correlation isweak.

It is unlikely, therefore, that CEOs have the right incentivesto take only those actions that benefit the owners of the firm.

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Work Incentives and DelayedCompensation

Upward-sloping age-earnings profiles might arise becausedelaying the compensation of workers until later in the lifecycle encourages them to allocate more effort to the firm.

A delayed-compensation contract also implies that at some point in the future the contract must be terminated, thusexplaining the existence of mandatory retirement in the labormarket.

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Indifferent Between Constant Wage andUpward-Sloping Age-Earnings Profile

Earnings

C

D B

A

0 Nt * Years onthe Job

VMP

If the firm could monitor a workereasily, she would get paid her constantvalue of marginal product ( VMP ) over

the life cycle. If it is difficult tomonitor output, workers will shirk.An upward-sloping age-earnings

profile (such as AC ) discouragesworkers from shirking. Workers get

paid less than their value of marginal product during the first few years onthe job, and this loan is repaid inlater years.

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Efficiency Wages

Some firms might want to pay wages above the competitivewage in order to motivate the work force to be more productive.

The efficiency wage is set such that the elasticity of output withrespect to the wage is equal to 1. Efficiency wages create a pool of workers who are involuntarily

unemployed.

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The Determination ofthe Efficiency Wage

Output

qe

q

Z

X

Y

Wagewe 0 w

Total ProductCurve

The total product curveindicates how the firms outputdepends on the wage the firm

pays its workers. The efficiencywage is given by point X , wherethe marginal product of thewage (the slope of the total

product curve) equals theaverage product of the wage(the slope of the line from theorigin). The efficiency wagemaximizes the firms profits.

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End of Chapter 12