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LABOR MARKET CONTRACTS AND WORK INCENTIVES 1 Hewi-Lin Chuang, Ph.D. 2010/04/15

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PENSION PLANS CLASSIFIED BY BENEFIT DETERMINATIONS Defined Benefit Plans Ex. Defined Contribution Plans Ex. 401(k) plans Hybrid Plans Ex. (cash balance pension) 2

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DB VERSUS DC PLANS DB DC 3

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HYBRID PLANS Hybrid Plans DB DC Cash Balance Pension Plan DB DC IRA http://www.dol.gov/ebsa/FAQs/faq_consumer_cashbalanceplans.html 4

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VERSUS 1. 2. 3. 4. 5. 5

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2009 6

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REFERENCE http://www.bli.gov.tw/ http://www.bli.gov.tw/ http://www.lpsc.gov.tw/ http://www.lpsc.gov.tw/ 8

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Another set of factors influencing job choice and work effort decisions: employer compensation policies both at one point in time and over several period of time. L ABOR M ARKET C ONTRACTS AND W ORK I NCENTIVES ~ The Structure of Compensation ~ 9

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1. T HE E CONOMICS OF F RINGE B ENEFITS 1)Employee Preferences: Two categories of benefits: a) Payment in kind: compensation in the form of some commodity, e.g., insurance, paid vacation. Other things equal, people would rather receive $X in cash than a commodity that costs $X. However, other things are not equal. In kind payments offer employees a sizable tax advantage because for the most part, they are not taxable under current income tax regulations. 10

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b) Deferred compensation: compensation that is earned now but will be paid in the form of money later on. E.g., pension benefits Deferred compensation schemes enjoy a tax advantage over current cash payments. Because of lower income and special tax advantages given the elderly, the tax rates actually paid are relatively low. Note: With both kinds of benefits there is a loss of discretion in spending ones total compensation, which tends to render fringes inferior to cash payments in generating utility. On the other hand, the special tax advantage of benefits as compared with cash payments tend to increase the demand for fringe. 11

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2)Employer Preferences Suppose employers are totally indifferent about whether to spend $X on wages or $X on fringes, then the composition of total compensation is a matter of indifference to the employers, only the level of compensation is of concern. Suppose a firm must pay its workers $X per years to remain competitive in both the labor and the product markets. The various compensation packages a firm is willing to offer fall along the zero-profit isoprofit curve drawn between wages and fringes. 12

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Wage Rate Nominal Employer Cost of Fringe Benefits Employers Zero-Profit Isoprofit Curve The slope of the isoprofit curve is negative reflecting the fact that the firm can increase fringes only if it reduces wages. In this case, the isoprofit curve has a slope of 1, reflecting employers indifference about the composition of compensation. Note: By increasing compensation in the form of fringes rather than wages, employers can often avoid taxes and required insurance payments that are levied as a fraction of payroll. This will make it more costly for an employer to increase compensation by increasing salaries than by increasing benefits. 13

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A dollar spent on fringes could cost employers more or less than a dollar nominally spent on wages or salaries. When fringes enhance productivity more than a similar expenditure on wages would, the isoprofit curve will flatten. When fringes increase other costs or reduce productivity, the isoprofit curve will be steeper. Wage Rate Nominal Employer Cost of Fringe Benefits X X A B 14

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3)The Joint Determination of Wages and Fringes Wage Rate Nominal Employer Cost of Fringe Benefits Worker Y Worker Z WYWY WZWZ FYFY FZFZ X X XX traces out the actual offers made by all firms in this labor market. Those employees who attach relatively great importance to the availability of current spendable cash will choose to accept offers in which total compensation comes largely in the form of wages. (such as worker Y) employees who may be less worried about current cash income but more interested in the tax advantages of fringe benefits will accept offers in which fringe benefits form a higher proportion of total compensation. (worker Z) 15

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Note: Because firms that pay high wages usually also offer very good fringe benefits, it often appears to the casual observer that wages and fringes are positively related. Casual observation in this case is misleading because it does not allow for the influences of other factors, such as the demands of the job and the quality of workers involved. 16

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2. C URRENT S TATUS AND F UTURE P ROSPECT OF F RINGE B ENEFITS 1)Current Status There are three major types of benefits provided to employees: a) Paid: vacations, holidays, sick leave maternity leave etc. b) Insurance Plans: medical care, life, disability etc. c) Retirement and Saving Plans: defined benefit pension, profit sharing, employee stock ownership etc. d) Additional Benefits: parking, educational assistance, employee discount etc. 17

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2)Future Prospect Over the past few decades there have been considerable changes in the composition of employee benefits offered to workers. While many of these changes have brought a new philosophy, and a new administration of employee benefits, all indications point to a continual expansion and redefinition of employee benefits packages. 18

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a)Early Retirement Early retirement programs are designed to assist an organization in achieving some measure of cost savings in their direct wage bill. Typically, as employees tenure with an organization has grown in years, these employees salaries have risen to high levels. The key issue in early retirement programs is to provide enough incentive for the employee to voluntarily take an early retirement, while simultaneously allowing for the direct wage bill of the organization to be reduced. 19

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b)Parental Leave Parental leave can be defined as any leave from work, paid or unpaid, for employees to attend to child care responsibilities for a newborn infant or newly adopted child. Although the Family and Medical Leave Bill permits this time off, there is a financial concern: The 9 to 5 organization estimates that fewer than 40 percent of working women would be financially able to take an unpaid leave. There was an even greater controversy surrounding parental leave-do fathers deserve the same time off as mothers with respect to family leave? 20

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c)Children and Eldercare Another major trend affecting corporations today is the push for an increase in child- and elder-care benefits. Dual-career couples with children and/or elderly live-in parents need to have some assurance that child- or eldercare programs are available to them without major disruptions to their lives. Companies are beginning to recognize that when its employees are faced with a choice between their jobs and their families, the vast majority of employees clearly place their job second. American Express, IBM, Work Family Directions, and Allstate Insurance have joined forces to offer quality childcare at a facility that is in close proximity to all of their employees. In coming years, we can only expect such cooperative arrangements to continue when they are feasible to both the employer and the employee. 21

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d) Flexible Benefits: A benefit program in which employees are permitted to pick benefits that most meet their needs, within monetary limits imposed. 1. Flexible Spending Accounts. 2. Modular Plans. 3. Core-plus Options Plans. 4. Add-on Plans. 22

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3. T HE C OMPENSATION OF E XECUTIVES There has been a lot of interest in recent years in the salaries of high-level executives, such as chief executive officers, or CEOs. American CEOs have much higher salaries than their counterparts in Germany and Japan. For example, the average salary of the top 20 executives in the United States is $4.8 million, as compared to $1.8 million in Germany, and $530,000 in Japan. 23

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1)The Principal-Agent Problem The analysis of CEO compensation also raises a number of important questions in economics. In particular, what should be the compensation package of a person who runs the firm, yet does not own it? The CEO is an agent for the owners of the firm (the owners are also called the principals). The owners of the firm, who are typically the shareholders, want the CEO to conduct the firms business in a way that increases their wealth. 28

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The inevitable conflict between the interests of the principals and the interests of the agent is known as the principal-agent problem. The structure of CEO compensation can be interpreted in terms of a tournament where the vice-presidents compete for promotion, and where the winner runs the company. This interpretation explains why the prize spread is larger when executives are promoted to CEO than when executives are promoted from junior to middle- level management. 29

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T OURNAMENTS Firms award promotions on the basis of the relative ranking of the workers. A tournament might be used when it is cheaper to observe the relative ranking of a worker than the absolute level of the workers productivity. Workers allocate more effort to the firm when the prize spread between winners and losers in the tournament is very large. A large prize spread, however, also creates incentives for workers to sabotage the efforts of other players or to quit along the way. 30

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T HE A LLOCATION OF E FFORT IN A T OURNAMENT 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 (MR HIGH ) and the worker allocates more effort to the tournament. Dollars Effort MC MR HIGH Y X MR LOW F high F low 31

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2)The Link between CEO Compensation and Firm Performance 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. 32

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4. INCENTIVE PAY PAY SYSTEMS: PIECE RATES Piece rates are used by firms when it is cheap to monitor the output of workers. Piece-rate compensation systems attract the most able workers and elicit high levels of effort from these workers. Workers in these firms, however, may stress quantity over quality, and may dislike the possibility that incomes fluctuate significantly over time. 33

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T HE A LLOCATION OF E FFORT BY P IECE - R ATE W ORKERS Dollars q*q* r Output q ABLE MR MC MC ABLE 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. 34

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P AY S YSTEMS : T IME R ATES Time rates are used by firms when it is costly or impossible to monitor the output of workers. 35

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E FFORT AND A BILITY OF W ORKERS IN P IECE - R ATE AND T IME -R ATE J OBS Utility r Ability Piece-Rate Workers Time-Rate Workers Worker B Worker A x*x* 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. 36

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B ONUSES, P ROFIT - SHARING, AND T EAM I NCENTIVES Unlike piece-rate systems, profit-sharing programs suffer from the incentive problems that afflict all team efforts, particularly the free-riding problem. Evidence suggests that profit-sharing plans increase productivity. 37

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W ORK I NCENTIVES AND D ELAYED C OMPENSATION 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 implies that at some point in the future the contract must be terminated, thus explaining the existence of mandatory retirement in the labor market. 38

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I NDIFFERENCE B ETWEEN A C ONSTANT W AGE AND U PWARD -S LOPING A GE -E ARNING P ROFILE Earnings C D B A 0 Nt*t* Years on the Job VMP 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. 39

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E FFICIENCY W AGES 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. 40

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T HE D ETERMINATION OF THE E FFICIENCY W AGE Output qeqe q Z X Y Wage wewe 0 w Total Product Curve 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. 41

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W HY I S T HERE A L INK BETWEEN W AGES AND P RODUCTIVITY ? A high wage makes it costly for workers to shirk (i.e., they lose the wage if caught). People who are well-paid might work harder even if there is no threat of dismissal. Efficiency wages reduce the quit rate and increase output and profits. A firm that pays efficiency wages attracts a more qualified pool of workers, increasing the productivity and profits of the firm. 42