Labor Markets Attracting and Retaining Qualified Employees Chapter 14 Incentive Compensation: Safelite (A)

1. Labor Markets Attracting and Retaining Qualified Employees Chapter 14 Incentive Compensation: Safelite (A)

2. 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

3. 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?

4. 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.

5. 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

6. Perfectly Competitive Modelwage determination

7. 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

8. 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

9. Average Annual earnings by Educational Attainment

10. 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.

11. 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”

12. 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?

13. Upward sloping earnings profile Bad Cops, Bad Cops Or Good Cops? Why do Cops receive relatively generous retirement pay?

14. Compensation componentssalary 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

15. 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

16. Optimal mix between salary and benefits

17. 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. “

18. 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

19. 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

20. Basic principal-agent modelRisk If replace some base pay with variable compensation • More variability in pay; increased risk • Must give higher expected compensation (“compensating differential”)

22. 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

23. 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?

24. 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