Compensation and incentives
Managing compensation:
A map of concepts and tools
(Baker, Jensen & Murphy’ 88)
▪ Compensation level
♦  where people work: recruitment, turnover
▪ Compensation composition
♦  the value (cost, utility) of a certain level
▪ Compensation function
♦  performance
Compensation level
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= Value of “job package”:
♦ effort, money, term, human capital, specificity, fringe benefits, etc.
How to set up? Multidimensional, lack of prices  Look at:
♦ turnover
♦ queues of qualified candidates
♦ costs and benefits of turnover
Job rating systems (“Hay” plans)  aggravates bureaucracy
“Efficiency wages” = higher than market wages  Two origins:
♦ Market  compensation level or function?
♦ Regulation  rent seeking
Compensation composition
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Should not trigger conflict between parties
Effects on labor relations
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Effects on other relations
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Growing demand for flexibility:
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Marketing view of compensation package: selling jobs
♦ Self-selection: e.g., health plans, deferred  low subjective
discount rate
♦ Moral hazard: paying with product discourages theft
♦ Self-control: pensions, work safety
♦ Adverse selection: reduces transaction costs by grouping: health
insurance
♦ Moral hazard: e.g., easily-to-enforce credit to employees
♦ Tax avoidance by paying in kind
♦ Demographic variety and change  ‘Flexible compensation’
Compensation function (1)
▪ How compensation level depends on
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performance
Basic types of variable compensation
♦ Piece rates, commissions, bonus plans, etc.
♦ BUT not only money, not only short term:
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Task allocation between subordinates
Promotions and salary revisions
Firing and penalties
Non-vested pensions and deferred compensation
Compensation function (2).
Effects and limitations of pay for performance
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Big problem in economics literature, small in real life:
“inefficient” risk allocation (principal-agent model)
Main real problem: produces harder effort and smarter effort—
BUT poses measurement problems:
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Gap between performance and contribution to firm value
Quality: Moscow taxis; MBO and killings of civilians in Viet Nam
Gaming: reallocation of performance between periods or units
Externalities:
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Sabotage of others in relative performance, between shifts  Pay
compression useful to enhance cooperation
Damage to clientele: reputation effects
♦  Important to group together activities in which performance can
be measured in a similar way
1st party
enforcement
Uncertainty
3rd party, judicial
enforcement
Effort
2nd party
enforcement
Performance
Firm value
Observable
performance
Incentives
Verifiable
performance
3rd party
enforcement
Compensation Function (3). Group or
individual?
▪ Key issue: relative advantage of specialized
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versus mutual performance evaluation
Larger group size makes specialization
relatively preferable
Greater within-team interactions make mutual
systems preferable
Compensation Function (4). Puzzles
in variable compensation
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Short term not predominant, even in the US—but
long-term variability hard to estimate
Asymmetric use of prizes and punishments: wage
reduction damages morale and is seen as unfair 
better to dismiss underperformers
Use of ceilings —to avoid aberrant effects? Aberrant
results, exogenous risk, equality.
Use of minimums despite causing reallocation (e.g.,
in sales, public works)—as insurance?
Compensation function (5).
Performance evaluation
▪ Objective evaluation
♦ Objective aberrations
♦ Contractual problems: standards
tricky to set and move
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Employees self-protect through social
norms stipulating a certain effort
Difficult to change: ‘ratchet’ effect with
piece rate: moving standards   
– Factors: technical change, trust
– Famous ‘Lincoln Electric’ case Next
Working / Careers at Lincoln Electric
(http://www.lincolnelectric.com/corporate/career/openings.asp)
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“Both entry-level and skilled positions require working a rotating shift on
either a two or three shift basis. In addition, most plant operations positions
pay on a piecework basis. That means pay is based directly on output.
All of these positions offer excellent opportunities for quality-conscious,
productivity-minded individuals who are interested in being rewarded for
their excellent performance.
Incentive Performance - A Cornerstone of Our Culture. The Incentive
Performance System primarily attributed to James F. Lincoln has been in
place at Lincoln Electric since the early twentieth century. It has resulted in
one of the oldest "pay-for-performance" systems in the country, and is
frequently used for benchmarking by other businesses and studied by
academics around the world.
The Incentive Performance System in place in the U.S. Lincoln operations
features:
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An elected Advisory Board for direct and open communication with senior
management since 1914.
Piecework incentive rewards for all production work.
A profit-sharing Bonus Plan for employees paid annually at the discretion
of the Board of Directors since 1934.
Guaranteed Employment after three years of service. The company has
not exercised its layoff options in the U.S. operations since post war 1948.
401(k) plan offering the employee a variety of pre-tax investment options.
Competitive compensation and other benefits.
A Financial Security Program which includes company contributions based
on years of service from 4 - 10%.
An attractive vacation package based on comparable years of service.”
“Through this well-defined group of
incentives, Lincoln encourages and
compensates individual initiative and
responsibility. Employees work together
to reduce costs and improve quality.
These individual and cooperative efforts
create a more profitable company, the
success of which each person shares
according to his or her own contribution.”
Compensation function (5).
Performance evaluation
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Objective evaluation
Subjective evaluation
♦ Corrects objective aberrations (Baker/Gibbons/Murphy QJE ‘94)
♦ Requires relational contracting, 2nd party enforcement
♦ Causes subjective aberrations
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Systematic and unintentional failures  Questionnaires
Rent-seeking ( “influence”) activities
♦ Rejected by middle managers (b/c we value ourselves too bad / too good in
absolute / relative terms)  Important: amounts & expectations
Frequency of evaluation:
♦ Cost: Measurement + Rent seeking
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E.g., promotions in Japanese firms, entry in Civil Service
♦ Value: before specific investments
Compensation function (6). Careers
& deferred compensation
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Compensating labor in the long term
Examples: Seniority, non-vested pensions, pantoufles, audit
firm’s partners, professions with entry barriers, etc.
Long term  investment  expropriation risk if specific
Compensation function (7). Deferred
compensation—Main issues
▪ Why?
♦ Performance unobservable in the short run (e.g.,
quality, professionals)
♦ Also: “specific” human capital (e.g., info required
for coordination); employees’ risk aversion (?)
▪ How?
♦ Compensation through quasi-rents: deferred
compensation
Compensation function (7).
Consequences of deferred compensation
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Self selection of people with low discount rate 
more fraud-adverse?  Lower expected turnover
Stronger effort, if future compensation is not vested
(threat of losing quasi-rents)
♦ What happens with professionals’ regulation?
But quasi-rents can be expropriated 
♦  Might be better to determine promotions and deferred
compensation by seniority than by evaluating performance
♦  Vested compensation  still self-selection, but not
stronger effort: e.g., Civil Service, promotions in Japan
Compensation function (8)
How to contract careers
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Mandatory law
♦ Permanent employment: dismissal triggers established
indemnity  3rd party, judicial enforcement  parties cannot
opt out legally
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May trigger workers’ opportunism 
Less incentive for employers to contract 
More careful and personal selection, high capital intensity,
unemployment,
Enabling law
♦ Idem unless parties contract out, agreeing e.g. on
termination at will
♦ Employer performs “quasi-judicial” function often with the
help of workers’ boards (e.g., Japan, Lincoln Electric)
Compensation function (9)
More issues on careers
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Mandatory retirement
♦ Japan: 54 years for “permanent” employees
♦ Needed in final years b/c compensation > disutility of work
Promotions as a reward system
♦ Careful evaluation  controls for long term performance
♦ Matching problem (“Peter’s Principle”): also appointment:
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•  better when same abilities required in different ranks
•  Otherwise, does not motivate technical, salespeople, etc.
•  Two tracks needed
More 
Compensation function (&10)
Still more issues on careers
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Tournaments
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Prizes fixed in advance, allocated through relative performance
Spread between prizes is the motivating factor
When luck is more important, more spread needed for same effort
Advantages (M&R, 384): Ordinal information, Prize pool set in advance
Compensation of “Stars”
Tenure & Up or Out
♦ Common in consulting and professional firms and universities
♦ Explicit tenure helps recruiting good candidates: current workers do not feel
threatened
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(implicit tenure may result from the fact that matching improves with seniority.
Institutional constraints very important in Europe (not in Japan)
♦ “Up or out”
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fresh ideas
eliminates incentives to cheat by unfairly denying promotion: difference of gaps
needed to encourage employees to invest and employers to promote employees
less costly for “producers” of non-specific human capital: good outside Jobs
Managing our incentives