1 Models of Effort

2 The Principal-Agent Problem Human Resource Management is a separate field of study today. But, we in economics have a take on the field and that take is basically one of employers and employees attempting to overcome the principal-agent problem. The principal – in this context a employer or manager – wants an agent – a worker here – to behave in a certain way. But, the agent has a set of priorities that does not coincide with those of the principal and the agent can usually conceal some aspects of their behavior. Employers want workers to give effort for pay. Workers want pay with minimum effort. Next, let’s turn to a model of effort.

3 effort $ Here we have indifference curves for workers. Wages, measured in dollars, are a good thing. Effort is harder to quantify, but we think it is a bad thing in that we would prefer not to exert it. So, indifference curves here are upward sloping because in order to take on more effort workers need a higher wage to induce them to give up other things to bring forth the effort. w1 E2 E1 Indifference curves to the northwest have higher utility. One way to see this is that at a given wage a worker would be happier exerting less effort. Or, at a given effort level, higher wages would make a worker happier.

4 In this model workers choose the combination of a wage and an effort level that gives the maximize utility obtainable. Shirking Say a worker has agreed to wage w1 and effort E1 in the graph on the previous screen. If the worker gets the job the worker has an incentive to only give effort E2 because a higher level of utility would be achieved. So far, this model suggests managers 1) Need to be careful in hiring so that workers can achieve E1, 2) Have to monitor work performance, and 3) May have to dismiss workers & have the company give up any return on investment in the employee.

5 effort $ Here we have the firm’s perspective on things. We assume the firm is a price taker in the output market. w1 is the wage the firm offers. The total revenue line (TR) is based on the idea that with more effort more output results and the firm can sell more. Thus, TR grows with effort. At w1 the firm needs at least effort w1. At this effort level the total revenue not only has to cover the wage of the worker, but the TR must also cover other expenses and allow for w1 E1 normal profit. Normal profit is what the firm would earn in its next best alternative. TR

6 The TR line on the previous slide had P times Q. In general, let’s say for the individual that Q = aE + v, where Q = output E = effort a = a parameter that connects effort to output v = a parameter that captures the effect on output from factors other than effort – an example is machine down time. On the previous slide we had a = 1 and v = 0, so Q = E. When this isn’t the case the line gets more complicated.

7 effort $ w1 E1 effort $ Here we bring the two previous graphs together. Note at w1 I have a dashed line until the solid part starts at E1. The idea is that the firm is only offering w1 if the minimum effort is E1. Workers who accept this type of job have utility level represented by the middle indifference curve. It is presumed that workers would take this job if it is their best available alternative. w1 TR

8 Concerns for manager with a fixed wage model Shirking – we see the potential to shirk here. Cost of shirking to worker is an expected cost. If the penalty form shirking is dismissal from the job then the cost of shirking is the probability of getting caught times the lost income. The individual will shirk if the utility gain is greater in value than the cost of shirking. The probability of getting caught is influenced by the firm. The firm can raise costs of monitoring and raise the probability. The worker has a trump card in that they can claim v is the reason for poor performance. Another point is that if w1 is the competitive wage workers may not care as much about getting caught shirking because they might think they can just go and get another job.

9 Another point is it does not appear that workers will give more than E1 effort. But the firm might like to see workers give more effort. Extension of the model – more effort more pay Let’s say the wage is tied to effort like this: w = -B + bE, where -B and b are parameters that connect effort to the wage. This means that we need to change our graph. Let’s turn to that next.

10 effort $ w1 E1 effort $ In this graph the worker has the same feeling about the fixed wage job and the job with performance pay. They would earn w1 and put forth effort E1 in either job. But, some workers might have flatter indifference curves. Let’s see this on the next slide. w1 TR w=-B + bE

11 effort $ w1 E1 E2 effort $ Here the worker prefers the performance pay job. A higher wage can be achieved compared to what is offered in the fixed wage environment. Implications for this model The system encourages self selection of workers. Workers decide which type of job to take. Those that opt for the performance pay have an incentive to put forth more effort. Firms do not have to worry as much about screening workers and shirking is less of an issue because the worker can not hide the amount of output produced. w1 TR w=-B + bE w2 With less spent on hiring and monitoring more can be given to worker and maybe there will even be more profit for the firm.

12 Difficulties of implementing performance pay jobs Many jobs have output that is hard to measure so the link to effort and output is hard to see. Some jobs have too many other factors that influence output besides effort and thus the link between effort and output is obscured. Some jobs depend on team effort – some workers could shirk. That reminds me of a story about China. Product would be shipped on the river. The more trips that could be made the more workers could make. SO, each day the workers would pick among themselves “the whipper.” This person would crack the whip on those who where not rowing the boat hard enough.