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.
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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.
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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
Slide 15
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)
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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
Slide 17
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
Slide 18
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
Slide 19
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
Slide 20
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
Slide 21
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
Slide 22
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
Slide 23
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
Slide 29
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
Slide 30
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
Slide 31
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
Slide 32
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
Slide 33
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.
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Slide 34
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
Slide 35
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
Slide 36
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
Slide 37
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
Slide 38
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
Slide 39
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
Slide 40
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
Slide 41
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
Slide 42
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