Chapter 7: Alternative Pay Schemes and Labor Efficiency

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Chapter 7 Alternative Pay Schemes and Labor
Efficiency
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• 1. Economics of Fringe Benefits

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Fringe Benefits as a Proportion of Compensation

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Relative Growth of Fringe Benefits

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• 2. Theory of Optimal Fringe Benefits

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Worker Indifference Map

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

Wages

• Fringes benefits are somewhat substitutable
  for wages even though most fringe benefits are
  in-kind benefits (benefits for a specific good
  or service).

I3
I2

• Workers substitute wages for fringe benefits
  because wages are taxed, but fringe benefits are
  not.

I1

• They also may substitute wages for fringe
  benefits to insure money is available for health
  insurance and retirement.

Fringe Benefits
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Employers 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.

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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).

• 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
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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.

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Causes of Fringe Benefit Growth

• 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.

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Causes of Fringe Benefit Growth

• 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.

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Causes of Fringe Benefit Growth

• Efficiency considerations
• Employers prefer to have lower turnover to
  protect their training investments and reduce
  recruiting costs.
• Fringe benefits such as pensions reduce worker
  turnover.
• Over time, training by firms have increased and
  so firms have had increased incentive to use
  fringe benefits to reduce turnover.

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• Questions for Thought

1. 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 230
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?
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• 3. Principal-Agent Problem

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Principal-Agent Problem

• 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.
• Firms have a profit incentive to reduce
  principal-agent problems.

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• 4. Pay for Performance

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Piece Rates

• Piece rates are compensation paid in proportion
  to the number of units of output.
• Piece rates limit the amount of shirking.
• Drawbacks
• May be difficult to set rate.
• They increase income variability and so firms
  will have to pay a premium.
• Difficult to use where team production is
  employed.
• Workers may decrease quality.

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Commissions and Royalties

• Commissions and royalties are compensation paid
  in proportion to the value of sales.
• These are efficient where work effort is
  difficult to observe.
• Authors, sales people, recording artists

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Raises and Promotions

• 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.

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Bonuses

• 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.
• Personal performance bonuses
• Based on evaluation by superiors or quantifiable
  measure.
• May have unintended effects.
• Workers schmooze superiors.

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Bonuses

• 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.

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Profit Sharing

• Profit sharing is a pay system that allocates a
  portion of the firms profits to its employees.
• In 1997, 16 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.

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Tournament Pay

• 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.
• The CEO position may be first place in a
  tournament.
• CEOs are paid more than their personal MRP, but
  other executives increase their MRP in hopes of
  getting the top prize.

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Highest Paid CEOs, 2002

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Tournament Pay and CEOs

• Implications
• Managers who dont 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.

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Tournament Pay and CEOs

• Criticisms
• May not be optimal since participants may
  sabotage anothers performance.
• Pay may because executives determine the pay of
  other executives by serving on the corporate
  boards of other firms.

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• 5. Efficiency Wage Payments

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Efficiency Wage Payments

• Firms may reduce shirking by monitoring the
  efforts of workers.
• Monitoring workers is costly in some cases.
• Babysitters, security guards, managers
• One solution is to pay an above-market wage.

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Wage-Productivity Dependency

• A higher wage may increase worker productivity
  by
• Increasing employee work effort
• Improving worker capabilities
• Increasing the proportion of skilled workers in
  the workforce.
• An efficiency wage is one that minimizes an
  employers wage cost per effective unit of labor
  employed.
• The marginal benefit of a higher wage equals the
  marginal cost of the higher wage.

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Efficiency Wage Theories

• Shirking model
• Paying an above-market wage will increase the
  relative wage of the job.
• This raises the opportunity cost being cost of
  being terminated for shirking.
• Workers increase their effort (productivity) in
  response to this higher opportunity cost.
• Labor turnover model
• Firms increase wage to reduce turnover.
• The lower turnover increases productivity since
  more experienced workers dont quit as often.

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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.

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Criticisms

• Alternatives to efficiency wages exist such as
  piece rates and commissions.
• Workers could post a bond they would forfeit is
  they were found negligent.
• Employers could reduce shirking by deferring part
  of workers pay.

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• Questions for Thought

1. 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 fund raising 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.
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• 6. Deferred Payment Schemes

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Deferred Pay Contracts

• In the diagram is MRP constant over the
  persons 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 ones
  career, may discourage shirking and reduce
  turnover.

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

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Role of Pensions

• 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 workers
  pay is greater than their MRP.
• 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.

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Final Points

• 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 a deferred pay
  contract.
• Large firms are less likely to cheat on a
  deferred pay contract by firing older workers.

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EndChapter 7