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Chapter 7: Alternative Pay Schemes and Labor Efficiency
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1. Economics of Fringe Benefits
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Fringe Benefits as a Proportion of Compensation
71%
7%
7%
8%4% 3%
Wage andSalaries
Legally RequiredBenefits
Paid Leave
Insurance
Retirement
Supplemental Pay
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Relative Growth of Fringe Benefits
0
5
10
15
20
25
30
Fringe Benefits as a Percent of Compensation
1929 1955 1965 1975 1986 1995 2000 2003
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2. Theory of Optimal Fringe Benefits
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Worker Indifference Map
Fringe Benefits
Wages• The indifference curves show the
combinations of wages and fringe benefits that yield the same amount of total utility.
I1
I2
I3
• Fringes benefits are somewhat substitutable for wages even though most fringe benefits are in-kind benefits (benefits for a specific good or service).
• Workers substitute wages for fringe benefits because wages are taxed, but fringe benefits are not.
• They also may substitute wages for fringe benefits to insure money is available for health insurance and retirement.
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Employer’s Isoprofit Curve
• An isoprofit curve (WF) shows the combinations of wages and fringe benefits that yield the same amount of profits.
• We assume that competition will yield a normal profit.
• This curve shows the combinations of wages and
fringes the firm can afford to provide, given the “prices” of wages and fringe benefits.
Fringe Benefits
Wages
W
F
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Wage-Fringe Optimum
• The optimal combination of wages and fringe benefits is at B, where the isoprofit curve is tangent to the highest attainable indifference curve (I2).
F0
W0
• Here the firm will provide W0 wages and F0 fringe benefits.
• Points A and C are also attainable combinations of
wages and fringe benefits, but they yield less total utility since they are on a lower indifference curve (I1).
A
C
Fringe Benefits
Wages
F
W
I1
I2
I3
B
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Fringe Benefit Growth• A decrease in the price of
fringe benefits due to tax advantages, scale economies, and efficiency considerations fans the normal isoprofit line outward.
• This allows the worker to attain a higher indifference curve (I2
rather than I1).• In the process, fringe benefits
expand from F0 to F1.
I1
I2
A B
Fringe Benefits
Wages
W
F F’
W0
F1F0
W1
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Tax advantages to employers Fringe benefits reduce the taxes the
employers pay. Employers pay half of the Social
Security tax. If employers substitute fringe benefits
for wages, their taxes will be reduced. The Social Security tax rate and base
have increased over time This rotated out the isoprofit curve and
increased fringe benefits.
Causes of Fringe Benefit Growth
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Economies of scale The are significant scale economies in
the provision of fringe benefits. Firms have grown in size over time
and lowered the per unit cost of fringe benefits. This rotated out the isoprofit curve and
increased fringe benefits.
Causes of Fringe Benefit Growth
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Efficiency considerations Employers prefer to have lower
turnover to protect their training investments and reduce recruiting costs. Fringe benefits such as pensions
reduce worker turnover. Over time, training by firms have
increased and so firms have had increased incentive to use fringe benefits to reduce turnover.
Causes of Fringe Benefit Growth
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Questions for Thought:1. The U.S. Office of Management and Budget has
estimated that the tax-exempt status of fringe benefits such as pensions and group insurance reduces tax revenue to the U.S. Treasury by $230 billion annually. Some economists have suggested that the federal government recover this tax revenue by taxing fringe benefits as ordinary income. Use a diagram to explain how this proposal would affect (a) the slope of indifference curves and (b) the slope of the isoprofit curve. What would be the likely effect on the optimal level of fringe benefits?
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3. Principal-Agent Problem
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The principal-agent problem occurs when agents (workers) pursue some of their own objectives which are in conflict with the goals of the principals (firms). Workers can increase their leisure by
shirking (working slowly or taking unapproved breaks) on the job. The profits of the firm will be lowered.
Firms have a profit incentive to reduce principal-agent problems.
Principal-Agent Problem
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4. Pay for Performance
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Piece rates are compensation paid in proportion to the number of units of output. Piece rates limit the amount of shirking.
Drawbacks May be difficult to set rate. They increase income variability and so
firms will have to pay a premium. Difficult to use where team production is
employed. Workers may decrease quality.
Piece Rates
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Commissions and royalties are compensation paid in proportion to the value of sales. These are efficient where work effort
is difficult to observe. Authors, sales people, recording artists
Commissions and Royalties
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Raises and Promotions
• If a worker is paid by the hour, the worker will choose point A with an annual income equal to Y1with L1 hours of leisure.
• An equivalent annual salary of Y1, the worker can get to a higher indifference curve I2 by increasing hours of leisure to L2.
• The worker can get this higher level of utility by shirking.
• The firm can overcome this incentive problem by offering future raises or promotions to those who consume L1 hours or less of leisure.
Leisure
Annual Income
L0
W
I1
L1
Y1
A
I2
B
L2
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Bonuses are payments beyond the annual salary based on some factor such as personal or firm performance. Elicit extra work effort and are not
permanent costs. Personal performance bonuses
Based on evaluation by superiors or quantifiable measure.
May have unintended effects. Workers schmooze superiors.
Bonuses
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Team performance bonuses Based on team performance. Leads to the free-rider problem.
Workers have less incentive to work hard as the size of the group rises since their own effort matters less.
Team performance bonuses work best when the size of the group is small.
Bonuses
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Profit sharing is a pay system that allocates a portion of the firm’s profits to its employees. In 1997, 16% were in a profit sharing
plan. Supporters argue that profit sharing
gives workers the incentive to work harder to increase firm profits.
Critics argue that it suffers from the free-rider problem.
Evidence indicates a modest positive effect on productivity.
Profit Sharing
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Tournament pay plans base compensation on relative performance. A large prize exists for top performer,
smaller prize for second place, and so on. Encourages all participants to exert more
effort. The CEO position may be first place in a
tournament. CEO’s are paid more than their personal
MRP, but other executives increase their MRP in hopes of getting the top prize.
Tournament Pay
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Highest Paid CEOs, 2002
Name Company
Total Pay (millions)
Alfred Lerner MBNA $194.9
Jeffrey Barbakow Tenet Healthcare 116.6
Millard Drexler Gap 91.0
Dennis Kozlowski Tyco International 71.0
Irwin Jacobs Qualcomm 63.3
Charles Cawley MBNA 48.6
Robert Kotick Activision 43.3
Ralph Roberts Comcast 39.8
Charles Fote First Data 39.1
Orin Smith Starbucks 38.8
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Implications Managers who don’t quite make it to CEO
will also be paid more than their MRP. “Golden parachute” provisions in
executive contracts provide protection against losing the full amount of CEO prize in takeover.
Tenure in CEO position is short because firms need to provide openings for others.
Tournament Pay and CEOs
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Criticisms May not be optimal since participants may
sabotage another’s performance. Pay may because executives determine the
pay of other executives by serving on the corporate boards of other firms.
Tournament Pay and CEOs
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5. Efficiency Wage Payments
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Firms may reduce shirking by monitoring the efforts of workers.
Monitoring workers is costly in some cases. Babysitters, security guards, managers
One solution is to pay an above-market wage.
Efficiency Wage Payments
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A higher wage may increase worker productivity by: Increasing employee work effort Improving worker capabilities Increasing the proportion of skilled
workers in the workforce. An efficiency wage is one that
minimizes an employer’s wage cost per effective unit of labor employed. The marginal benefit of a higher wage
equals the marginal cost of the higher wage.
Wage-Productivity Dependency
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Shirking model Paying an above-market wage will
increase the relative wage of the job. This raises the opportunity cost being cost
of being terminated for shirking. Workers increase their effort (productivity)
in response to this higher opportunity cost. Labor turnover model
Firms increase wage to reduce turnover. The lower turnover increases productivity
since more experienced workers don’t quit as often.
Efficiency Wage Theories
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Non-Clearing Markets• Suppose a firm finds it can lower
its effective cost per unit of labor by increasing the wage rate from W1 to W2.
• The lower cost is the result of increased productivity of the workers. This reflected in a rightward shift in the labor demand curve from D1 to D2.
• Though W2 is an equilibrium wage, it results in a labor surplus of BC and is not the market clearing wage.
• The unemployment of BC workers generates part of the productivity gain since the threat of unemployment encourages workers not to shirk.
D2
W2
Q1
W1
D1
Quantity of Labor Hours
Wage rate S
A
B
Q2
C
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Alternatives to efficiency wages exist such as piece rates and commissions.
Workers could post a bond they would forfeit is they were found negligent.
Employers could reduce shirking by deferring part of worker’s pay.
Criticisms
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Questions for Thought:1. Speculate on what actions workers might take
to resolve a free-rider problem.
2. People often sell goods (or raffle tickets) as part of a fund raising project. These projects typically offer valuable prizes to those who sell over a fixed number of units. Often a grand prize, say, a trip to Hawaii is offered to the person who sells the most units. Why are these prizes offered? Relate this example to the high pay received by chief executive officers of large corporations.
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6. Deferred Payment Schemes
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Deferred Pay Contracts• In the diagram is MRP constant
over the person’s worklife.
• Firms and workers may enter into implicit contracts that increase pay as years of service rise.
• Younger workers receive pay that is less than their MRP, while older workers are paid more than their MRP.
• The prospect of high pay at the end of one’s career, may discourage shirking and reduce turnover.
Wage
MRP
Quantity of Labor Hours
Wag
e ra
te, M
RP
• Because of the increased productivity, workers may get higher lifetime earnings than if wages equaled MRP each year.
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With deferred pay contracts, workers may not want to retire at the normal age due to their high pay. This is not optimal for firms since the
worker’s pay is greater than their MRP. Pensions solve this problem by providing
generous benefits if workers retire in certain age ranges. Pension also raise MRP by reducing
turnover. Benefits are much higher for those with high
tenure.
Role of Pensions
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Deferred pay contracts are most likely in large established firms. Workers may be more difficult to
monitor in large firms. Large firms are less likely to go
bankrupt and so younger workers are more willing a deferred pay contract.
Large firms are less likely to cheat on a deferred pay contract by firing older workers.
Final Points
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EndChapter 7
