Labor MarketsAttracting and Retaining Qualified Employees

Chapter 14

Incentive Compensation:

Safelite (A)

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

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?

# Check-out Lanes Total Customers/hour MP MRP1 20 x x2 403 554 655 706 717 71.5

Demand for labor in benchmark modelMRP = 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.

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

Perfectly Competitive Modelwage determination

Market Wage Determination

Price-Taking Firm Choice of qL

Sum all firms' qL*'s

QL

e

W=PL W=PL

Slabor

Dlabor

Amt of labor

PLe

QLe

qL*

dlabor =

marginal value

of labor

Marginal cost of L

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

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

Average Annual earnings by Educational Attainment

1978 1998

Men

High school, no college $31,847 $28,742

College graduates $52,761 $62,588

Percent extra for college grads +66 percent +118 percent

Women

High school, no college $14,953 $17,898

College graduates $23,170 $35,431

Percent extra for college grads +55 percent +98 percent

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.

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”

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?

Upward sloping earnings profile

Bad Cops, Bad CopsOr Good Cops?

Why do Cops receive relatively generous retirement pay?

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

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

Optimal mix between salary and benefits

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. “

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

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

Basic principal-agent modelRisk

If replace some base pay with variable compensation

More variability in pay; increased riskMust give higher expected compensation

(“compensating differential”)

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

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?

Looking ForwardNovember 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