Incentive pay

1
Incentive pay

• How can you afford to pay your men so well?
  (Bankers question to Andrew Carnegie)
• I cant afford to pay them any other way
  (Carnegies reply)

2
The Wage Distribution in the United States, 2002
3
Human resource management practices in large firms
Source Lazear and Shaw, 2007
4
The main problem

• Principal (company owner(s))-agent (employee/CEO)
  problem
• Principal
• Agent
• Conflict of interest

5
Piece rate versus time rate pay systems

• Piece rates are used by firms when it is cheap to
  monitor the output of the workers.
• Time rates are used by firms when it is costly or
  impossible to monitor the output of workers

6
The Allocation of Effort by Piece-Rate Workers
The piece rate is r dollars, so the marginal
revenue of an additional unit of output equals r.
The worker gets disutility from producing
output, as indicated by the upward-sloping
marginal cost of effort curve. The level of
effort chosen by a piece-rate worker equates
marginal revenue to marginal cost, or q units.
If it is easier for more-able workers to allocate
effort to their jobs, they face lower marginal
cost curves and produce more output.
7
Effort and Ability of Workers in Piece-Rate and
Time-Rate Jobs
All workers, regardless of their abilities,
allocate the same minimal level of effort to
time-rate jobs. Because more-able workers find
it easier to allocate effort, they will allocate
more effort to piece-rate jobs and will have
higher earnings and utility. Workers with more
than x units of ability sort themselves into
piece-rate jobs, and less-able workers choose
time-rate jobs.
8
Example Lazear (2000) Performance pay and
productivity, AER, 90 (5), 1345-1361

• Hypothesis the average productivity will rise,
  the firm will attract the most able workers and
  the variance of output of employed workers will
  rise in the aftermath of the introduction of the
  piece-rate system
• Results Mean and standard deviations of key
  variables

9
Example Lazear (2000) Performance pay and
productivity, AER, 90 (5), 1345-1361

• Other results
• - Simple regressions show that there is a 44
  gain in productivity from the move to a PPP
  regime
• - The incentive effect accounts for about 22
• - The rest is explained by sorting

10
Evidence on the use of piece rate systems
Lazear (2000) piece rate proportions in the NLSY
11
Alternative incentive pay methods
Source Lazear and Shaw (2007)
12
The logic behind bonus compensation

• Example Computer sales MC900, Revenue1000

13
The logic behind bonus compensation

• PayabRevenuea profit from employee sales
• Optimal commission ratebRevenue-MCmarginal
  profit on next sale
• Firm profitProfit from employees sales-Pay-a
• In other words, the best incentive is to sell
  the job to the employee
• Examples Cab drivers, waiters, etc.

14
The logic behind bonus compensation formally

• Agents problem
• Principals problem

15
Promotions Acme example
Source Lazear-Gibbs
16
Tournaments

• Incentive creation
• Drawbacks
• - Risk e.g. manager in Denmark vs manager in
  Singapore
• - Sabotage, etc

17
The Allocation of Effort in a Tournament
The marginal cost curve gives the pain of
allocating an additional unit of effort to a
tournament. If the prize spread between first
and second place is large, the marginal revenue
to an additional unit of effort is very high
(MRHIGH) and the worker allocates a lot of effort
to the tournament.
18
Example 1 Ehrenberg and Bognanno (1990) Do
tournaments have incentive effects? JPE, 98 (6),
1307-1342.

• Institutional characteristics of the 1984s PGA
  tournament

19
Example 1 Ehrenberg and Bognanno (1990) Do
tournaments have incentive effects? JPE, 98 (6),
1307-1342.

• Estimation/ results

20
Example 2 Bognanno (2001) Corporate
tournaments, JOLE, 19(2), 290-315.
Executive characteristics by level, Bognanno
(2001), pp. 293.
21
Example 2 Bognanno (2001) Corporate
tournaments, JOLE, 19(2), 290-315.

• Regression analysis

22
Example 2 Bognanno (2001) Corporate
tournaments, JOLE, 19(2), 290-315.
23
Example 2 Bognanno (2001) Corporate
tournaments, JOLE, 19(2), 290-315.
24
Policy Application Compensation of CEOs

• There is a positive correlation between the
  compensation of CEOs and the performance of the
  firm, but the correlation is weak.
• It is unlikely, therefore, that CEOs have the
  right incentives to take only those actions
  that benefit the owners of the firm.

25
Work Incentives and Delayed Compensation

• Upward-sloping age-earnings profiles might arise
  because delaying the compensation of workers
  until later in the life cycle 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, thus explaining the existence of
  mandatory retirement in the labor market.

26
Indifferent Between Constant Wage and
Upward-Sloping Age-Earnings Profile
If the firm could monitor a worker easily, she
would get paid her constant value of marginal
product (VMP) over the life cycle. If it is
difficult to monitor output, workers will shirk.
An upward-sloping age-earnings profile (such as
AC) discourages workers from shirking. Workers
get paid less than their value of marginal
product during the first few years on the job,
and this loan is repaid in later years.
27
Why is there mandatory retirement? (Lazear 1979,
JPE, 87(6))

• Model estimated
• Result strong positive effect of
• on the probability of having a mandatory
  retirement clause in the labor contract

28
Efficiency Wages

• Some firms might want to pay wages above the
  competitive wage in order to motivate the work
  force to be more productive.
• The efficiency wage is set such that the
  elasticity of output with respect to the wage is
  equal to 1.
• Efficiency wages create a pool of workers who are
  involuntarily unemployed.

29
The Determination of the efficiency wage
The total product curve indicates how the firms
output depends on the wage the firm pays its
workers. The efficiency wage is given by point
X, where the marginal product of the wage (the
slope of the total product curve) equals the
average product of the wage (the slope of the
line from the origin). The efficiency wage
maximizes the firms profits.