Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Chapter 7

Alternative Pay Schemes and Labor Efficiency

7-2

1. Economics of Fringe Benefits

7-3

Fringe Benefits as a Proportion of Compensation

7-4

Relative Growth of Fringe Benefits

7-5

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 White-Collar occupations

o Fringes greater in Union vs. Non-Union jobs

7-6

2. Theory of Optimal Fringe Benefits

Why have fringes grown and is it desirable?

7-7

Worker Indifference Map

Fringe Benefits

Wages• The indifference curves show the combinations of wages and fringe benefits that yield the same amount of total utility.

I1

I2

I3

• 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.

7-8

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.

Fringe Benefits

Wages

W

F

7-9

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).

F0

W0

• Here the firm will provide W0 wages and F0 fringe benefits.

• 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).

A

C

Fringe Benefits

Wages

F

W

I1

I2

I3

B

7-10

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).

• In the process, fringe benefits expand from F0 to F1. I1

I2

A B

Fringe Benefits

Wages

W

F F’

W0

F1F0

W1

7-11

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

7-12

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.

7-13

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.

7-14

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.

7-15

Question for Thought1. 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?

7-16

3. Principal-Agent Problem

How can firms structure pay to ensure performance?

7-17

Principal-Agent Problemo 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.

7-18

4. Pay for Performance

o Piece Rateso Commissionso Hourly Wages vs. Salaryo Bonuseso Profit Sharingo Tournament Pay

7-19

Piece Rateso 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.

7-20

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

7-21

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.

Leisure

Annual Income

L0

W

I1

L1

Y1

A

I2

B

L2

7-22

Bonuseso 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

7-23

Bonuseso 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.

7-24

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 free-rider problem.

• Evidence indicates a modest positive effect on productivity.

7-25

Tournament Payo 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.

7-26

Highest Paid CEOs, 2007

Name Company

Total Pay (millions)

Lawrence J Ellison Oracle 192.9

Frederic M Poses Trane 127.1

Aubrey K McClendon Chesapeake Energy 116.9

Angelo R Mozilo Countrywide Financial 102.8

Howard D Schultz Starbucks 98.6

Nabeel Gareeb MEMC Electronic Mats 79.6

Daniel P Amos Aflac 75.2

Lloyd C Blankfein Goldman Sachs Group 73.7

Richard D Fairbank Capital One Financial 73.2

Bob R Simpson XTO Energy 72.3

7-27

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.

7-28

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.”

7-29

5. Efficiency Wage Payments

7-30

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 above-market wage.

7-31

Wage-Productivity Dependencyo 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.

7-32

Efficiency Wage Theorieso 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.

7-33

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.

• 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

W2

Q1

W1

D1

Quantity of Labor Hours

Wage rate S

A

B

Q2

C

7-34

Criticismso 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.

7-35

Questions for Thought1. 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.

7-36

6. Deferred Payment Schemes

7-37

Deferred Pay Contracts• 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.

Wage

MRP

Quantity of Labor Hours

Wag

e ra

te, M

RP

• Because of the increased productivity, workers may get higher lifetime earnings than if wages equaled MRP each year.

7-38

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.

7-39

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.

7-40

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

7-41

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

7-42

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.

7-43

Case: Tenure for Facultyo 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.