Chapter 11 Incentive Pay

Chapter 11 Incentive Pay

Incentive pay • A compensation package designed to elicit particular levels of effort from the worker • Goal: to maximize productivity while simultaneously minimizing costs (labor costs here)

Labor Contracts v. Spot Markets • Spot Markets: one period where firms decide how much to hire, offer a wage, and it is accepted or rejected • Labor Contracts: long term contracts between the employer and the employee • Why would either (employer or employee) choose spot v. contract?

Piece Rates v. Time Rates • Piece Rates: compensates the worker according to some measure of the worker’s output • Time Rates: a worker is paid for a specific period of time worked (hourly, for example)

Depends on Transparency of Productivity • W = VMP • What if a firm can’t measure productivity? • Could MONITOR productivity… but this is costly (and then who monitors the monitor?) • If can’t measure productivity, offer time rates

Effort • Workers choose the amount of effort they are going to put into their job. • Assume: choose effort that maximizes utility • For piece-rate workers, more productivity leads to higher wages which leads to more utility • But more effort (presumably) causes “disutility” so the worker must balance this

Figure 1 page 466 • Illustrates the worker’s effort decision when she is paid a piece rate • Wage is constant r dollars per unit produced (marginal revenue from producing one more unit is r dollars) • This translates into a “marginal revenue of effort” curve that is horizontal • MC of effort curve is upward sloping (more effort causes “pain”) • Max utility where MR = MC (at q*)

And… if workers differ in ability • Differences in ability suggest that workers will behave differently. • Maybe more-able workers can produce more with less effort. • This means that more able workers will face a lower marginal cost of effort curve

So what does all this mean? • Piece-rate workers allocate effort so that MR of an additional unit of effort = MC of that effort • Because more able workers find it easier to produce, more able workers will allocate more effort to piece rate jobs

What about time-rate jobs? • Imagine that some minimal level of output (say q ) is both expected and easily monitored. This could be just showing up on time and sitting at your desk. • A time-rate worker will produce q units of output and no more. • If it is painful to produce and a worker can produce the minimum, then why not? • So they will get a salary of r x q • This is also the utility associated with the job.

Sorting: What kind of workers go to what kind of firms? • Figure 11 – 2 • All workers, regardless of ability get the same utility from time-rate jobs • If paid by piece rate, utility = f(ability)… Her utility depends on her ability. • Less-able workers produce less and get less income. • More able workers produce more and get more income.

Table 11-2 Continued: Worker Choices • Worker A is a “less able worker”. He/she is better off accepting a job offer from a time-rate firm. • Worker B is a “more able worker”. He/she is better off accepting a job from a piece-rate firm. • Workers with fewer than x* units of ability go to time-rate firms while workers with more than x* units of ability go to piece rate firms.

Empirical and Anecdotal Evidence? • (btw, what is “empirical” and what is “anecdotal” evidence?) • Empirical: Piece-rate workers are more productive and earn more than time-rate workers: • 13% more per hour in footwear • 15% more in men’s and boy’s suits and coats • 20% more in auto repair shops Can you think of other anecdotal examples?

Disadvantages of the Piece-Rate System • The piece-rate system attracts the most-able workers, elicits high levels of effort from the workforce, ties pay directly to performance, minimizes the role of discrimination, and increases the firm’s productivity. • But what if the firm’s production depends on team effort? • Such a system will overemphasize quantity of output • Risk associated with salaries that fluctuate • “Ratchet effect”– discourages innovation/efficiency

Bonuses, Profit Sharing • Bonuses – payments above and beyond salary, typically linked to the worker’s (and/or the firm’s) productivity. • Profit-sharing: redistributes part of the firm’s profits back to the workers

The Compensation of Executives • Table 11-1: the highest-paid CEO’s in the United States, 2007.

Principal-Agent Problem • What should be the compensation package of a person who runs the firm, yet does not own it? • CEO is an “agent” for the owners of the firm (owners are also called principals). • Goals of the principal and the agent are not always aligned. • Principal: want the CEO to conduct the firm’s business in a way that increases wealth. • CEO: wants to decorate office with expensive Impressionist originals.

Link between CEO pay and firm performance • Positive correlation, although the elasticity of CEO pay with respect to the rate of return to shareholders is small. • 10 percentage point increase in shareholders rate of return increases CEO pay by 1%

Chapter 11 Incentive Pay