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ECO 610-401

ECO 610-401. Monday, November 17 th Organizational Design: Centralized vs. Decentralized Internal Labor Markets Exam Review Review Sheet Readings, Brickley et al., 12, 14 Extend Assignment #2 Due Solutions on Website Monday, November 24 th Exam 2. Internal Pay Markets.

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ECO 610-401

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  1. ECO 610-401 • Monday, November 17th • Organizational Design: Centralized vs. Decentralized • Internal Labor Markets • Exam Review • Review Sheet • Readings, Brickley et al., 12, 14 • Extend Assignment #2 Due • Solutions on Website • Monday, November 24th • Exam 2

  2. Internal Pay Markets • Basic Theory equates MRP (Marginal Revenue Product) with Wage (earnings) • We have talked about a few extensions: • Impacts of Training • Job Market Signaling and Wages • Incentive Compensation • Consider more about the Lifetime Pay • Efficiency Wage • Upward Sloping Wage Profiles • Promotion Tournaments

  3. Efficiency Wages • Why would a firm pay more the MRP? • In what type of industries might you see this occur? • When might you see it during an employee’s career?

  4. Efficiency Wages and Termination • Employee’s Decision: Work hard or not? • Cost of working hard is $50 • If employee doesn’t work hard, firm can detect with probability of p < 1. • Firm pays w • Next best alternative is w**

  5. Efficiency Wages and Termination (2) • If employee works hard gets: • w - $50 • If doesn’t work hard gets • pw** + (1-p)w • (p chance of getting fired, 1-p of keeping job) • Will work hard if: • w - $50 > pw** + (1-p)w • or • p(w-w**) > 50  w > w** • Intuition: • Tradeoff between monitoring (p) and wage. If: • Monitoring is expensive then low p and need higher wage

  6. Efficiency Wages -- Evidence

  7. Wage Differentials by Industry

  8. Job Seniority and Pay • Why does salary increase with tenure on the job? • Are these increases in salary proportionate to increases in productivity and performance? • If not, why not? • Is there an element of efficiency wage in this?

  9. Job Seniority and Pay (2) • Assume that: • Firms cannot perfectly monitor performance • Suppose that firms offer a salary such that: • Salary < MRP for employees with little tenure • Salary > MRP for employees with long tenure

  10. Job Seniority and Pay (3) • Effects: • Younger workers have incentive to work hard & not get dismissed • Older workers also have incentive since they are earning a premium • Issue • Firm has incentive to fire anyone with Salary > MRP • Can it credibly commit not to do so? • Explicit “Seniority” rules for layoffs in downturns • Reputation – if it fires older workers, younger works reduce their performance incentives. • Forced retirement allows firm to end MRP > Salary in a credible way.

  11. Promotion • Hierarchical firms typically base compensation on a specific job level (Asst. Manager, Manager, Director, VP) • Promotion to these ranks is generally based on a tournament – competing against others in the firm for a job. • Then it is relative performance that matters • Advantage – reduces the role of other factors and therefore risk in evaluation.

  12. Promotion (2) • Why have significant increases in pay with promotion? • Employee effort will be based on how effort affects probability of promotion: • Payoff from effort: p(e)(w*-w) – c(e) • p(e) – probability of promotion • w* -- salary with promotion • w – salary without promotion (current) • c(e) – cost of effort

  13. Promotion (3) • Properties of Promotion Tournaments: • Effort increases with difference in salaries • If firm adds employees to tournament to keep same effort must increase prize (salary with promotion) • With successive rounds (promotions) to keep same effort must increase prize (difference in salaries) • Advantages of Tournaments • Reduces problems trying to differentiate between similar employees. • If attempt to divide pool among almost equal, little incentive to be best • Controls for common random factors in evaluation • Disadvantages of Tournaments • Conflict in providing incentives for lower-level jobs and selecting best person for higher-level job. • Employees have incentive to not work with or even against fellow employees.

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