Managerial Economics and Organizational Architecture, 5e
Managerial Economics and
Organizational Architecture, 5e
Chapter 14: Attracting
and Retaining Qualified
Employees
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.
Managerial Economics and Organizational Architecture, 5e
Contracting Objectives
• Firms wish to design employee
compensation contracts to maximize the
value of employee’s output net of costs
• Individuals must receive at least their
reservation utilities – the level of
satisfaction they could receive in their next
best alternative
• Compensation is a key to this utility
14-2
Managerial Economics and Organizational Architecture, 5e
Basic Competitive Model
Assumptions
• competitive labor market
– wages determined by supply and demand
•
•
•
•
current market wages costless to determine
workers are identical
all jobs identical
no long-term contracts
– all labor hired in “spot” market
• all compensation is monetary
14-3
Managerial Economics and Organizational Architecture, 5e
The Competitive Model of
Employment and Wages
– when MRP>wage the
worker adds more to
the value of the output
than to costs
– When MRP< wage the
worker costs more
than what he adds to
the value of output
Wage (in dollars)
Each firm hires until
MRP=market wage
$
Market wage rate
Marginal revenue product
E*
E
Number of employees
14-4
Managerial Economics and Organizational Architecture, 5e
Relaxing the Assumptions
• All jobs are not identical
– employees will choose most desirable job
for given level of pay
– firms must offer compensation for
undesirable characteristics
•
•
•
•
Workers are not perfect substitutes
Information is costly
Compensation takes many forms
Jobs may be long term
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Managerial Economics and Organizational Architecture, 5e
Human Capital
• Individuals differ in their abilities skills and
training
• General human capital is applicable to
many firms
– workers are willing to pay for general training
• Specific human capital is useful to the
current employer, but does not have much
value outside the job
– firms pay for specific training
14-6
Managerial Economics and Organizational Architecture, 5e
Compensating Wage Differentials
• Firms pay extra compensation to attract
workers to less desirable jobs
• Individuals averse to these less desirable
job attributes choose a lower paying job
without these attributes
• Workers and firms are matched by
workers desire for job attributes and the
firm’s ability to offer them
14-7
Managerial Economics and Organizational Architecture, 5e
Internal Labor Markets
• Outside hiring is for entry level jobs
• Promotions are from within
• This helps establish a long-term
employment relationship
14-8
Managerial Economics and Organizational Architecture, 5e
Long Term Relationships
• Result in greater levels of firm-specific
human capital investment
• Greater employee motivation
• Better matching of employees to jobs over
time
14-9
Managerial Economics and Organizational Architecture, 5e
Pay in Internal Labor Markets
• Since relationships are longer term, career
earnings are used in decision making
instead of MRP
• Firms can pay below MRP initially and
above MRP later in the relationship
14-10
Managerial Economics and Organizational Architecture, 5e
Upward Sloping Earnings Profile
$
Salary (in dollars)
Compensation
Marginal revenue product
T
Tenure with the firm
14-11
Managerial Economics and Organizational Architecture, 5e
Pay in Internal Markets
• Efficiency wages
– compensation higher than market rates
– can motivate workers not to shirk
– may reduce turnover
• Compensation typically rises with seniority
– higher productivity
– incentive to work in best interest of firm,
acquire firm-specific human capital
14-12
Managerial Economics and Organizational Architecture, 5e
Promotions as Tournaments
• Employees compete for promotions within
organizational hierarchy
• Promotion systems have drawbacks
– undermine cooperation
– more discrete than monetary rewards
– Peter principle may apply
– employees may not value promotions
– influence costs may rise
14-13
Managerial Economics and Organizational Architecture, 5e
Compensation Components
salary and fringe benefits
• Salary and fringe benefit compensation
are not perfect substitutes for employees
– the role of taxes
– groups may purchase fringes at lower price
• Employees may wish to trade between
salary and fringes to attain optimum
combination
14-14
Managerial Economics and Organizational Architecture, 5e
Employee Preferences for Salary
and Fringe Benefits
Salary (in dollars)
Employee preferences
U2
U1
$
Fringe benefits (in dollars)
14-15
Managerial Economics and Organizational Architecture, 5e
Employer Preferences for
Paying Salary or Fringe Benefits
$
Salary (in dollars)
Isocost curves
-1
-1
Fringe benefits (in dollars)
$
14-16
Managerial Economics and Organizational Architecture, 5e
The Optimal Mix Salaries
Versus Fringes
• Maximize firm value by meeting potential
employee’s reservation utility at lowest
cost
• Indifference curve is tangent to an isocost
line
14-17
Managerial Economics and Organizational Architecture, 5e
Salary
Optimal Mix Between Salary
and Fringe Benefits
S*
U
F*
Fringe benefits (in dollars)
$
14-18
Managerial Economics and Organizational Architecture, 5e
Salary-Fringe Benefit Choice
• Management should heed to preferences
of the employees and offer the benefits
they want
• Employees are willing to tradeoff salary for
benefits
• Must account for taxes on both the firm
and employee
• Be aware of secondary effects
– Sick leave may motivate absenteeism
14-19
Managerial Economics and Organizational Architecture, 5e
Salary (in dollars)
Optimal Choice of Salary and
Fringe Benefits with Payroll Taxes
S*
S’
U
Payroll taxes
No payroll taxes
F*
F’
Fringe benefits (in dollars)
14-20
Managerial Economics and Organizational Architecture, 5e
Attracting Particular Types of
Employees with the Salary-Benefits Mix
$
Salary (in dollars)
$S
Reservation utility:
Single person
$M
Reservation utility:
Married person
FS
FM
Fringe benefits (in dollars)
$
14-21