CH. 11. PAY AND PRODUCTIVITY: WAGE DETERMINATION WITHIN THE FIRM

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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

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• 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.

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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

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Piece Rates

• Employer preferences and piece rates.
• Advantages
• Productivity is increased among a given work
  force.
• Attract most productive workers.
• Disadvantages
• 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

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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.
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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 employeremployee
data. Cambridge Journal of Economics, v. 28
issue 5, 2004, p. 683.
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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.
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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.
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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.

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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

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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 AirlinesM Knez, D Simester - Journal
of Labor Economics, 2001
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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
  non-outsourced airports where employees were
  eligible for bonus.

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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.

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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.

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Efficiency Wages

• The trade-off between wages and monitoring
• qper period probability that a worker is
  detected shirking
• pefficiency wage premium per period
• Lexpected length of job
• Expected loss from shirking in a given
  periodqpL
• A worker will shirk if expected gain from
  shirking gt qpL

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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 qpL).

on monitoring
Isoquant (qpLconstant)
on efficiency wages
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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.

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Efficiency Wages

• Iso-cost curves further to the SW are lower
  levels of costs

on monitoring
Slope -1
Iso-cost
on efficiency wages
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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.
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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

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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
  five-dollar day.

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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
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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.

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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.

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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).

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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.

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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

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Tournament Theory

• Suppose that employees produce output according
  to
• Qi aei ui v
• ei person is effort
• ui random error affecting person is output
• v random error affecting all workers output
• e,u and v are unobservable to employer.

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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.

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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.

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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.