Alternative Pay Schemes and
Labor Efficiency
McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

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o Fringes greater in
• High-paying industries vs. Low-paying industries
• Goods-producing industries vs. Services
• Transport & Utilities vs. Retail Trade o Fringes greater in Blue-Collar than White-
Collar occupations o Fringes greater in Union vs. Non-Union jobs
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Why have fringes grown and is it desirable?
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• 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).
• Workers substitute wages for fringe benefits because wages are taxed, but fringe benefits are not.
• They also may substitute wages for fringe benefits to insure money is available for health insurance and retirement.
I
1
I
2
I
3
Fringe Benefits
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• An isoprofit curve (WF) shows the combinations of wages and fringe benefits that yield the same amount of profits.
Wages
W
• 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.
F
Fringe Benefits
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• The optimal combination of wages and fringe benefits is at
B, where the isoprofit curve is tangent to the highest attainable indifference curve (I
2
).
• Here the firm will provide W
0 wages and F
0 fringe benefits.
Wages
W
• 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 ( I
1
).
W
0
A
B
C
I
1
I
2
I
3
F
0
F Fringe
Benefits
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• A decrease in the price of fringe benefits due to tax advantages, scale economies, and efficiency considerations fans the normal isoprofit line outward.
Wages
W
• This allows the worker to attain a higher indifference curve ( I
2 rather than I
1
).
• In the process, fringe benefits expand from F
0 to F
1
.
W
0
W
1
A
B
I
1
I
2
F
0
F
1
F
F’
Fringe
Benefits
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o Advantages to employees
• Fringe benefits reduce the taxes the employees pay.
∞Employer pension contributions tax deferred
∞Retiree tax rates likely to be lower
∞Health contributions tax exempt
• Health insurance cheaper at group rates.
• Fringes are normal goods so demand increases as incomes rise
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o 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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o 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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o Efficiency considerations
• Employers prefer to have lower turnover to protect their training investments and reduce recruiting costs.
∞Fringe benefits such as pensions and health care reduce worker turnover.
• Over time, training by firms has increased and so firms have had increased incentive to use fringe benefits to reduce turnover.
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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 $350 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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o 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.
o Firms have a profit incentive to reduce principal-agent problems.
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o Piece Rates o Commissions o Hourly Wages vs. Salary o Bonuses o Profit Sharing o Tournament Pay
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o Piece rates are compensation paid in proportion to the number of units of output.
• Piece rates limit the amount of shirking.
o Drawbacks
• May be difficult to set rate as APL changes.
• They increase income variability and so firms will have to pay a premium.
• Difficult to use where team production is key: who made what & decreased cooperation
• Workers may decrease quality.
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o Unlike piece rates, commissions and royalties are compensation paid in proportion to the value of sales.
• These are efficient where work effort is difficult to observe but job performance tied to sales
∞Authors, sales people, recording artists
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• If a worker is paid by the hour, the worker will choose point A with an annual income equal to
Y
1 with L
1 hours of leisure.
Annual Income
I
2
I
1 • An equivalent annual salary of Y
1
, the worker can get to a higher indifference curve I
2 by increasing hours of leisure to L
2
.
W
• The worker can get this higher level of utility by shirking.
Y
1
• The firm can overcome this incentive problem by offering future raises or promotions to those who consume L
1 less of leisure.
hours or
0
A
L
1
B
L
2
L
Leisure
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o 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.
o Personal performance bonuses
• Based on evaluation by superiors or quantifiable measure.
• May have unintended effects.
∞Workers schmooze superiors.
∞Workers work to bonus items, nothing else
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o 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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o Profit sharing is a pay system that allocates a portion of the firm’s profits to its employees.
• In 2008, 11.2 million workers 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 freerider problem.
• Evidence indicates a modest positive effect on productivity.
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o 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.
o The CEO position may be first place in a tournament.
• CEO’s are usually paid more than their personal MRP, but other executives increase their MRP in hopes of getting the top prize.
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Name Company
Lawrence J Ellison Oracle
Frederic M Poses Trane
Aubrey K McClendon Chesapeake Energy
Angelo R Mozilo Countrywide Financial
Howard D Schultz Starbucks
Nabeel Gareeb MEMC Electronic Mats
Daniel P Amos Aflac
Lloyd C Blankfein Goldman Sachs Group
Richard D Fairbank Capital One Financial
Bob R Simpson XTO Energy
Total Pay
(millions)
192.9
127.1
116.9
102.8
98.6
79.6
75.2
73.7
73.2
72.3
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o Implications
• Managers who don’t 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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o Criticisms
• May not be optimal since participants may sabotage another’s performance.
• Pay may be excessive because executives determine the pay of other executives by serving on the corporate boards of other firms, i.e., “mutual admiration societies.”
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o Firms may reduce shirking by monitoring the efforts of workers.
o Monitoring workers is costly in some cases.
• Babysitters, security guards, managers o One solution is to pay an abovemarket wage.
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o A higher wage may increase worker productivity by:
• Increasing employee work effort
• Improving worker capabilities
• Increasing the proportion of skilled workers in the workforce o An efficiency wage is one that minimizes an employer’s 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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o Shirking model
• Paying an above-market wage will increase the relative wage of the job.
∞This raises the opportunity cost of being terminated for shirking.
∞Workers increase their effort (productivity) in response to this higher opportunity cost.
o Labor turnover model
• Firms increase wage to reduce turnover.
∞The lower turnover increases productivity since more experienced workers don’t quit as often.
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• Suppose a firm finds it can lower its effective cost per unit of labor by increasing the wage rate from W
1 to W
2
.
• The lower cost is the result of increased productivity of the workers. This reflected in a rightward shift in the labor demand curve from D
1 to D
2
.
• Though W
2 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.
Wage rate
W
W
1
2
B
Q
1
A
C
S
D
1
D
2
2
Q
Quantity of
Labor Hours
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o Alternatives to efficiency wages exist such as piece rates and commissions.
o Workers could post a bond they would forfeit if they were found negligent.
o Employers could reduce shirking by deferring part of worker’s pay.
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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 fundraising 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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• In the diagram is MRP constant over the person’s 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 one’s 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.
Wage
MRP
Quantity of
Labor Hours
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o 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 worker’s pay is greater than their MRP.
o 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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o 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 to have a deferred pay contract.
• Large firms are less likely to cheat on a deferred pay contract by firing older workers.
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o Standard economic theory asserts that wages and employment are tied to individual productivity o Most workers, however, get annual COLA adjustments and have seniority rights because of principal-agent problem o Firms need workers to train new workers because most skills are OJT
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o Seniority based pay & employment rights
• Maximizes transmittal of knowledge between existing employees
• Minimizes resistance to new knowledge and processes
• Minimizes resistance to the hiring of new productive workers o Merit-based pay and employment rights would create principal-agent problems
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o Historically tenure is designed to ensure academic freedom = ability to explore and express unpopular positions o Criticized as diminishing work effort and departmental productivity (best young profs slotted to principles classes) o Some have argued political power of faculty with colleges has preserved it.
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o Tenure can be viewed as a cure for a serious Principal – Agent problem
• Existing faculty choose new faculty
• w/o tenure, would recommend the weakest
• w/tenure, senior faculty willingly participate in search for best new faculty
• Tenure aligns interests of senior faculty and administration
• Tenure problems are addressed with buyouts, generous retirement benefits.
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