1

Variable pay or straight salary

University Professors get a straight salary – which is mainly based on age – which might be considered high or low, depending on your point of view.

Should we introduce incentive pay, e.g. by # of exams or scientific papers written

What are the tasks of academics?What about fixed jobs without layoff risk?What are problems of incentive pay?

2

Incentive pay

Should pay be based on input or output?How should output be defined?Does paying for output cause workers to

seek the wrong goals?Does output-based compensation

induce people to focus on the short-run only?

Should it be tied to individual or group output?

3

Why choose output based pay?

Positive influence on hiring and retention also known as adverse

selection low ability workers will

look for jobs that pay by input rather than output

workers who do not want to work hard are likely to leave the firm.

If you can sell > 5, you go to thecompany with output based pay. If < 5 you go to the flat base pay

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4

Example: taxi drivers

Driver rents the car, pays for gas and keeps all revenues

orCompany gives the driver the cab, pays

for gas and they split the revenues 50:50

Some problems with second scheme??? Moral hazard on the side of the driver Efffort of driver is sub-optimal

5

Agency Theory or Principle-Agent-Model

Implicit assumptions Worker is averse to effort E (otherwise

everything is just fine) Worker is averse to risk (otherwise the

problem is simple) The parties cannot contract on the level

of effort E (otherwise they would write a contract on e, leaving the employer all the risk)

6

A simple model with risk neutrality

Disutility of effort E is C(E); i.e. the worker does not exert effort E0 unless he gets at least C(E0) paid.

How does the worker choose effort optimally – to max his utility:

total compensation (risk neutral!!) minus effort cost

==> marginal effort cost should be equal to marginal return for effort

Max E C(E)

C'(E) = 0.E

7

How does the firm choose and ?

Firm will try to maximize profits, but has to check: Choice of will determine Effort E Total compensation must be high enough to

keep the worker with the firm, i.e.

Assume E is equal to output also==>

==>

* *E C(E )

Max E - - E = E - C(E)

E1 C'(E) 0 ==> 1 = C'(E) =

8

Surprising result: worker should get the whole additional output

If risk-neutral: worker should act as „residual claimant“ – worker acts like an entrepreneur

Only this contract will allow the optimal choice of effort

How does the firm make profit in this case? ==> choose as high as possible, so that

profit increases, but worker should be willing to sign the contract!

9

Example: salesperson‘s commission

Marginal cost for computers $900Market price $1000Optimal commission is $100 per

piece sold.Optimal for worker as it seems, but

is this really optimal for the firm???

10

Findings at Safelite Glass Corporation

(Based on Lazear, E.P., Performance pay and productivity, American Economic Review, 2000, 1346-1361)

switch from salaries to piece rates induced a 36% increase in productivity

about 2/3 of this is due to incentives, rest is due to changing composition of the workforce

Pay increased by 9%Remarks about Quality and External validity

11

Why don‘t you see workers often paying for their jobs?

Principle idea: 100% commission rate, and

worker has to pay in order to get the job No explicit payment, but implicit

Is it better to have, say, 10% in sales or 100% in

profits?Moral hazard on the side of the firm!

Capital market imperfections do not allow buying

the firm, which would be sometimes the best

solution to maintenance problems

12

Problem gets more complicated in reality and with risk-aversion of workers

1st principle of optimal insurance: the party who can more easily absorb risk (ie the party that is

most risk neutral) should insure the other party. employees are likely to be more risk averse than the firm. The

firm should not avoid risks if avoiding would lead to lower profits. Stockholders can diversify risk across investments. They want the firm to earn the highest profit possible. Therefore the firm should insure the employees

the firm can pay lower wages if it accepts the risk

firms that pay by output will need to pay higher compensation. If they do not get greater productivity, it is a waste

13

Sometimes output is difficult to measure

Possible that variations in output are due to external factors that

are not controllable by the employee. Unless the firm can

condition on these factors it may be difficult to give the proper

incentives.

If the work of the employee depends upon coordination with other

employees, it may be difficult to single out their individual

contribution. It may be necessary to pay on a team basis.

There may be multiple tasks. Incentives must be balanced across

different tasks. If it is difficult to measure the performance on one

task, strong incentives on other tasks will result in the employee

ignoring that task. There can be a severe problem of distortion of

incentives.

14

Equal Compensation Principle

If the worker has two tasks, either compensate effort alike in both, or don‘t use incentive contracts Quality versus quantity Sales today versus next year... University professors do teaching and

research

15

It may be difficult to set the rate.

Workers have incentives to slow down when you are attempting to set the appropriate rate.

Management has the incentive to increase the required rate when the workers easily surpass their old levels of productivity. This is called the ratchet effect. Since workers realize that the ratchet effect exists, they will be reluctant to work to their full capacities or they may try to force other workers to work at less than full capacity.

16

In case of risk aversion of workers ...

The higher the ability of workers, the stronger should be incentives.

The higher the risk aversion among workers, the lower the incentives

should be.

The stronger the effect on company profits of increased effort by the

employee, the greater the incentives should be

The stronger the impact on effort, the greater the incentive should be.

The greater the precision of measurement of output, the greater the

incentive should be.

17

Different types of pay-performance payment

Output based measures often involve quotas, bonus payments, caps or promotions

Quotas are very good as long as the workers are homogeneous. However, they suffer from the problems of discontinuity: little incentive if there is low prob. of making the quota and little incentive after the quota is made.

18

Bonus or Penalty

Consider 2 different job offers: Scheme A pays $10,000 per month plus a

bonus of $1 for every unit sold Scheme B pays $15,000 per month with a

5,000 unit quota: penalizing the worker with $1 for every unit below the quota

suppose it‘s not possible to produce more than 5,000 to make it simple

What is more attractive for workers?Which job offer creates the highest

incentives?

19

What‘s the psychology behind these schemes?

„only use positive rewards“ Theory of loss aversion (Kahneman and Tversky):

experiments showing that people hate more to give up something they think they own.

Establish a rule (social norm) you think people should obey

Economic considerations: Use bonus when there is no cost to poor performance Use penalty if there is no benefit to high performance Examples??

20

Performance pay for Managers (CEOs)

Two views: CEOs are overpaid; board of directors do

not represent shareholders’ interests, they also are too short-term oriented

CEOs are worth every nickel they getWhat should CEOs maximize?

importance of efficient market hypothesis

21

Empirical evidence

Compensation through stock options in a much higher proportion for US CEOs

Some results for the US Pay and firm size: 10% extra sales, 2-3%

extra salary pay and performance: pay responds to

performance intensity of incentives: largest estimate 3.25

for 1,000 increase in shareholder value

22

Question:

CEOs often receive a substantial part of their compensation as variable pay. It is difficult to measure the CEO's performance. You are a compensation consultant. To which of the following accounting measures do you propose to tie executive compensation?

Change in earnings reported by the company. EBIT or change thereof. Change in revenues. Change in the market value of the company. Change in market value relativ to change in Dow

Jones.

23

Answer

What you should consider: Discretion of manager to influence

bookkeeping figures Influence of short- vs. long-term

investments Is the market valuation rational? What does the „relative compensation“

do

24

Question:

Both CEOs and VPs tend to have a certain

percentage of their compensation tied to

the company’s overall per-formance. Who

(VPs or the CEO) should have a larger

percentage of wages tied to the company

performance?

Explain.