Labor Markets
Attracting and Retaining Qualified Employees
Chapter 14
Incentive Compensation:
Safelite (A)
Perfectly competitive labor market (Benchmark model )
of employment and compensation
Assumptions
• competitive labor market
– wages determined by supply and demand
• current market wages costless to determine
• all jobs identical
• no long-term contracts
– all labor hired in “spot” market
• all compensation is monetary
Value of labor
•
•
•
Compute MP of each checkout person (lane)
If revenue net of cost of goods per customer is $25, compute MRP (marginal revenue
product) – the revenue each new checkout lane brings in
If wage is $30, how many lanes to open?
# Check-out Lanes Total Customers/hour MP
1
20 x
2
40
3
55
4
65
5
70
6
71
7
71.5
MRP
x
Demand for labor in benchmark model
MRP = MP x P
Each firm hires to point
where
MRP=market wage
•Labor demand satisfies
this equality
•Labor earns its marginal
(revenue) product
•The Labor Theory of
Value (Marx) is
completely false.
Productivity growth raises
workers’ MRP, which raises
workers’ wages.
Managerial implications
• If you pay less than market wage, can’t fill
positions
• If you pay more than market wage, you’re
at a cost disadvantage
Perfectly Competitive Model
wage determination
W=PL
W=PL
Slabor
Marginal
cost of L
PLe
dlabor =
Dlabor
marginal value
of labor
QLe
Market Wage
Determination
Amt of
labor
qL*
Price-Taking Firm
Choice of qL
QLe
Sum all firms' qL*'s
Relaxing the benchmark assumptions
• All jobs are not identical
– employees will choose most desirable job for
given level of pay
– firms must offer compensation for undesirable
characteristics (compensating differential)
•
•
•
•
Workers are not perfect substitutes
Information is costly
Compensation takes many forms
Jobs may be long term
Human Capital
• Specific Vs General
• Decision to invest depends on Net Present Value
of costs and benefits
• Firms have little incentive to invest in general and
employees have little incentive to invest if firm
specific
• Usually increase with tenure => Wages usually
increase with tenure
• Education can be a screening device
Average Annual earnings by Educational Attainment
1978
1998
High school, no college
$31,847
$28,742
College graduates
$52,761
$62,588
+66 percent
+118 percent
High school, no college
$14,953
$17,898
College graduates
$23,170
$35,431
+55 percent
+98 percent
Men
Percent extra for college grads
Women
Percent extra for college grads
Labor Market Turnover
•Costly to both employees and firms
•Loss of specific human capital
•Hiring costs - search and training
•Most separations come from workers with little
tenure
•Match Capital - Incomplete information when
someone is hired, Good matches are more likely to
survive.
Internal Labor Markets
• Some non-entry jobs may be filled by individuals
from within the organization
• This is the “internal labor market”
• Long-term relationships with employees
• Often governed by “implicit contracts” – informal
understandings
• Increase investment in Human Capital
• Help to generate “Match Capital”
Long term employment
• Compensation typically rises with seniority
– higher productivity (MRP)
• Maybe compensation rises faster than productivity
(MRP) – incentive to work in best interest of firm,
acquire firm-specific human capital
– Risky for employees – is the firm viable?
Upward sloping earnings profile
Bad Cops, Bad Cops
Or Good Cops?
Why do Cops receive
relatively generous
retirement pay?
Compensation components
salary plus benefits
• Salary and benefit compensation are not
perfect substitutes for employees
– the role of taxes
– groups may purchase benefits at lower price
– Benefits inflexible; salary flexible (in use)
• Employees may wish to trade between
salary and benefits to attain optimum
combination
Benefits in U.S.
• Employee Benefits = 29.2 % of Total Comp.
– Among Large Employers, 1993
•
•
•
•
•
•
Legally required payments (SSI, etc.)
Retirement
Insurance
Paid Rest, vacations, sick leave, etc.
Miscellaneous (perks, etc.)
Source: U.S. Chamber of Commerce, Employee
Benefits 1993
Optimal mix between salary
and benefits
Optimal choice of salary and benefits with taxes
“With less than two months
until the end of the year -traditional bonus paying time
-- executives at the securities
firms and recruiters who work
with them predict bonuses
will increase by an average of
10% to 20% compared with a
year earlier. Though that
likely will still leave them far
below the go-go times of a
few years ago, it could
nonetheless mark a turning
point in fortunes for the
battered securities industry. “
Risk and incentive compensation
• Factors outside employees’ control
• Risk aversion
=> incentive pay contracts must balance motivation vs. risk bearing
Examples
• CEO performance: bonuses, stock options
• Professors: 1700’s – universities gave fees to professors for
attracting more students
• Weather forecasters: Kursk, USSR: bonuses tied to % of accurate
forecasts
• Columbus: Spain monarchy entitled him to 10% of “all gold,
gems, …tax free”
• Salespeople: paid on commission
• Lincoln Electric and Safelite
Basic principal-agent model
• Effort not directly observable – use proxy
– “post contractual asymmetric information”
• Outside risk factor
– Could work hard but not all measured
=> Compensation contract
– tie incentive pay to proxy to motivate effort
– Include base pay to reduce risk bearing
Basic principal-agent model
Risk
If replace some base pay with variable
compensation
More variability in pay; increased risk
Must give higher expected compensation
(“compensating differential”)
Safelite Glass
• 600 small auto-glass repair centers
• 1994 – pay for performance introduced
– Hourly wages = f(base salary, glass installed)
– Minimum base salary = $11/hr
– Must install defectives without pay
• Benefits: TBA
• Costs: TBA
• Net effect: TBA
• Source: E. Lazear, “Performance Pay and Productivity,”
The American Economic Review, Dec. 2000
Safelite Glass
• Why was the productivity of Safelite installers so low?
• What is PPP trying to accomplish?
• What are the likely consequences of a switch from wage rates to
piece rates for:
–
–
–
–
–
Turnover
Recruitment
Productivity
Product Quality
Total Labor Costs
• (How) will PPP succeed?
• What are the potential pitfalls in PPP?
• Should management proceed with the introduction of
PPP or even a modified PPP?
Looking Forward
November 29,30 and December 2
• Incentive Compensation
– Chapters 15
– Case Readings: Safelite (B)
• Course project presentations and discussions
December 6, 7, and 9
• Performance Evaluation
– Chapters 16 and 17, Arthur Anderson
– Final Project Due
December 13, 14, and 16
• Final Exam