Alternative Pay Schemes and Labor Efficiency

Fringe benefits Total compensation of employees = wages + fringe benefits Fringe benefits = public programs(like social security) + private programs(like medical and dental, pensions, paid vacation and sick leave). About 72% of compensation is in wages and 28% is in fringes. In 1955 fringes made up about 15% of compensation.

Optimal fringe benefit theory To understand why something like fringe benefits has changed in our economy, economists come up with theories. The theory we will look at is a modification of the labor leisure model we saw earlier. Our theory will have indifference curves and a budget constraint.

Indifference curves Remember that an indifference curve shows combinations of goods that yield the same level of utility for the individual. The goods we are talking about here are wages and fringe benefits. The indifference curves for an individual summarize their subjective view about the trade-off between wages and fringe benefits. Some have wondered why fringe benefits would be of interest to people. It seems that a dollar in fringe benefits is less beneficial than a cash equivalent. As an analogy consider the following: Which would you rather I give you, a snicker bar or the money amount of the snicker? With the money you could buy the snicker bar or something else, if that made you happier.

Indifference curves There are two reasons fringe benefits (FBI) may be traded-off with wages: 1) tax advantages 2) may be the only way we ‘buy’ some things

tax advantage Example Say a worker has no FBI, has 30,000 in income, the first 20,000 of which is taxed at 15% and the rest at 28% and the worker puts 2,000 into retirement. The tax for the worker is 20,000(.15)+10,000(.28) = 5,800. After taxes and retirement the worker has 22,200 left to spend. Now say a worker has FBI in that 2000 can be put into retirement before it is taxed as income. The tax for the worker is 20,000(.15) + 8000(.28) = 5240 and after the tax and retirement the worker has 22,760 left to spend. The fringe leads to 560 tax decrease. Maybe we would trade FBI for wages.

‘buy’ what is good for us For many of us we get paid and that money is spent before our next paycheck - we enjoy the good life. We are willing to give up wages because we will still enjoy the good – save 10% of all you earn and you probably won’t notice a difference. we will get some stuff like health care and pension plans that we might not have purchased on our own. Without the fringe benefit we might be like a kid in a candy store and not get exactly what we really should.

indifference curve graph wages fringe benefits So the indifference curves are much like we have seen in the past. They are downward sloping and convex to the origin.

The budget line The budget line represents what the worker can trade-off in the market. But here the firm plays a role. The firm looks at total compensation of employees to figure what maximum profits might be. If the firm takes a dollar of wages away and gives a dollar of FBI, its compensation wouldn’t change. So initially our understanding of the budget is that for every dollar given up by firms, a dollar in FBI is returned. W 1 1 FBI

The budget line The budget line can actually rotate counter clockwise if we consider 1) tax advantages to the employer 2) economies of scale 3) efficiency of labor with fringes. On the budget line farther out, the firm can give back more than a dollar of FBI when a dollar of wages is taken away. W 1 1 FBI

tax advantage for employer Say a worker gets paid 30,000. The firm has to contribute 7.65% of income to social security and medicare. This means the firm has to pay 2295 in social security tax. The real cost to the firm is 32295 to have this worker work in the firm. When FBI are given the dollar value is not subject to social security taxation. So if the firm takes a dollar of wages away it can offer the dollar plus the tax saving of 7.65 cents back in FBI.

Economies of scale If each worker bought their own insurance it would cost x dollars. With the firm buying a group plan, the group rate means the worker could get more than x dollars worth of insurance for the same x dollars if those dollars are now taken as FBI. I am a bit skeptical of this argument. If this really is the case, why don’t we do our car insurance the same way?

efficiency All dollars in expense to the firm are not the same. Let’s us an example to try to see what this means. case 1 Workers only stay at a company for a year because there are no FBI. year 1 $1 in training cost yields x output. year 2 $1 in training cost yields x output. case 2 Workers stay longer than a year because of FBI year 1 $1 of training cost yields x output. year 2 $1 of FBI yields x+y output. So workers that stay longer at a firm may become more productive and thus the firm can offer more than a dollar in FBI for every dollar of wages taken away.

optimal amount of FBI W The optimal amount of FBI occurs where the worker can get on the highest indifference curve but still be on the budget line. This occurs on curve 2 and the worker gets the amount of FBI represented by FB1. 1 2 3 FBI FB1

optimal amount of FBI W Over time as the budget line has shifted out due to the ideas mentioned above, we see the the optimal amount of FBI has increased(so have wages). 1 2 3 FBI FB1 FB2