1. RKO Warner Video Videotape rental firm in NYC Problems
In video stores in NYC (one of the largest stores at the time)
Big inventory of tapes
High quality service
Attractive décor
Problems
Turnover was very high
Quality and consistency of store managers varied across the chain

2. RKO Warner Video Decision rights were bundled into jobs
Store manager tasks:
Make sure videos are alphabetized
Keep the store clean
Make sure the store opens and closes on time
Reward system didn’t motivate effort
1988: Bonus plan introduced
Pre-bonus managers made $21-28,000
Post-bonus made more in bonuses than with regular pay. Average salary rose by an average of 15%

3. Contracting Objectives
It is in the interest of both employee and firm to maximized the value created in the relationship
Reservation Utility
Individuals will not participate in a labor relationship until they obtain at least the utility they can get elsewhere. This is called the “reservation utility.”
In a competitive market, paying more than the competitive amount may put the firm at a disadvantage relative to other firms

4. Basic Competitive Model
Labor market is competitive (no discretion over wages)
Market Wages are costless to observe
Workers are identical
Jobs are identical
All labor is rented on the spot market
All compensation is monetary

5. Basic Competitive Model
Wage in $
Market Wage Rate
Marginal Revenue Product of labor E E*
Number of Employees

6. Human Capital Basic Terminology Types of Human Capital Human Capital
Investment in Human Capital
“rate of return” on Human Capital
Types of Human Capital
General
Specific

7. Compensating Differentials
Must pay more when a job has undesirable characteristics
$ more must by paid for every 1/10,000 increase in the probability of being killed on the job
Compensating differentials provide a reward for firms making jobs safer or more pleasant. For example, the above statistics imply that a firm with 1,000 employees could reduce wages by $20,000-$300,000 per year by preventing one accidental death every 10 years.

8. Compensating Differentials
Compensating differentials get people to do unpleasant jobs
Compensating differentials provide reward for firms that make jobs more pleasant
Compensating differentials allow workers to self-select by willingness to take risks

9. Costly Information About Market Wages
Compensation may be hard to see
Workers differ in human capital so they may differ in the compensation offered
Firms don’t share all of the details of compensation with prospective employees
Symptoms…
…of over-paying: too many qualified applicants
…of under-paying: few applicants, high turnover

10. Problems with under-paying
Low compensation is associated with high turnover so costs of re-training are high
When turnover is high there may be incentive problems

11. Internal Labor Markets
Some firms hire entry level positions externally, but train and promote from within the firm
In 1991 an employee between 45 & 54 had typically been with the same employer for 10 years or longer
Half of all men and ¼ of women stay with the same firm at least 20 years
Most Internal Labor Markets rely on implicit contracts

12. Tradeoffs in Long-Term Employee Agreements
Advantages of internal labor markets
Accumulates more firm-specific human capital
Better motivation
There is incentive to avoid behavior that is dysfunctional in the long run
Managers know more about employee attributes
Costs of internal labor markets
Restricted competition for advanced jobs

13. Pay in Internal Labor Markets
Often employees are asked to take less money early in their career than they could get elsewhere, but they are paid more than they could get elsewhere later
Compensation
Salary
Marginal Revenue Product of Labor
Tenure with the firm

14. Tradeoffs with Career Earnings
Advantages
Efficiency wages reduce turnover and shirking
Since pay rises faster than MRPL employees have strong incentives to make the firm look good
Promotions become a reward for good behavior
Disadvantages
Promotions may be manipulated because of destructive behavior toward other rivals
Promotions are a crude incentive tool since they are infrequent
The Peter Principle
Much time may be spent lobbying managers for promotions

15. The Salary-Fringe Benefit Mix
Fringe Benefits account for about 25% of compensation for the average American
Examples
Health Insurance
Non-Social Security pension programs
Subsidized Education
Discounted Meals

16. Indifference Curves Between Salaries and Fringe Benefits
Monetary Compensation
Utility = U2
Utility = U1
Fringe Benefits

17. Iso-Cost Lines Between Salaries and Fringe Benefits
$50 K
Iso-cost line at $50,000 ($50K) of total payment
Monetary Compensation
Slope = -1
$50K
Fringe Benefits

18. Iso-Cost Lines Between Salaries and Fringe Benefits
$50 K
Monetary Compensation
$30K
$20K
$50K
Fringe Benefits

19. Fringe Benefits Payroll taxes Applications
Make the iso-cost line flatter
The total tax-bill (including the part paid by the employees) will matter in determining the optimal mix of fringe benefits
Applications
Fringe benefits can be used to screen for particular types of employees
Cafeteria-style plans are desirable when administration costs are low and when adverse selection is not a problem.