1. Managerial Economics and Organizational Architecture, 5e Managerial Economics and Organizational Architecture, 5e Chapter 14: Attracting and Retaining Qualified Employees McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All Rights Reserved.

2. Managerial Economics and Organizational Architecture, 5e Contracting Objectives Firms wish to design employee compensation contracts to maximize the value of employee’s output net of costs Individuals must receive at least their reservation utilities – the level of satisfaction they could receive in their next best alternative Compensation is a key to this utility 14-2

3. Managerial Economics and Organizational Architecture, 5e Basic Competitive Model Assumptions competitive labor market –wages determined by supply and demand current market wages costless to determine workers are identical all jobs identical no long-term contracts –all labor hired in “spot” market all compensation is monetary 14-3

4. Managerial Economics and Organizational Architecture, 5e The Competitive Model of Employment and Wages Each firm hires until MRP=market wage –when MRP>wage the worker adds more to the value of the output than to costs –When MRP< wage the worker costs more than what he adds to the value of output Market wage rate Number of employees E* E Marginal revenue product Wage (in dollars) $ 14-4

5. Managerial Economics and Organizational Architecture, 5e Relaxing the Assumptions All jobs are not identical –employees will choose most desirable job for given level of pay –firms must offer compensation for undesirable characteristics Workers are not perfect substitutes Information is costly Compensation takes many forms Jobs may be long term 14-5

6. Managerial Economics and Organizational Architecture, 5e Human Capital Individuals differ in their abilities skills and training General human capital is applicable to many firms –workers are willing to pay for general training Specific human capital is useful to the current employer, but does not have much value outside the job –firms pay for specific training 14-6

7. Managerial Economics and Organizational Architecture, 5e Compensating Wage Differentials Firms pay extra compensation to attract workers to less desirable jobs Individuals averse to these less desirable job attributes choose a lower paying job without these attributes Workers and firms are matched by workers desire for job attributes and the firm’s ability to offer them 14-7

8. Managerial Economics and Organizational Architecture, 5e Internal Labor Markets Outside hiring is for entry level jobs Promotions are from within This helps establish a long-term employment relationship 14-8

9. Managerial Economics and Organizational Architecture, 5e Long Term Relationships Result in greater levels of firm-specific human capital investment Greater employee motivation Better matching of employees to jobs over time 14-9

10. Managerial Economics and Organizational Architecture, 5e Pay in Internal Labor Markets Since relationships are longer term, career earnings are used in decision making instead of MRP Firms can pay below MRP initially and above MRP later in the relationship 14-10

11. Managerial Economics and Organizational Architecture, 5e Upward Sloping Earnings Profile Tenure with the firm T $ Salary (in dollars) Compensation Marginal revenue product 14-11

12. Managerial Economics and Organizational Architecture, 5e Pay in Internal Markets Efficiency wages –compensation higher than market rates –can motivate workers not to shirk –may reduce turnover Compensation typically rises with seniority –higher productivity –incentive to work in best interest of firm, acquire firm-specific human capital 14-12

13. Managerial Economics and Organizational Architecture, 5e Promotions as Tournaments Employees compete for promotions within organizational hierarchy Promotion systems have drawbacks –undermine cooperation –more discrete than monetary rewards –Peter principle may apply –employees may not value promotions –influence costs may rise 14-13

14. Managerial Economics and Organizational Architecture, 5e Compensation Components salary and fringe benefits Salary and fringe benefit compensation are not perfect substitutes for employees –the role of taxes –groups may purchase fringes at lower price Employees may wish to trade between salary and fringes to attain optimum combination 14-14

15. Managerial Economics and Organizational Architecture, 5e Employee Preferences for Salary and Fringe Benefits Employee preferences Fringe benefits (in dollars) $ Salary (in dollars) U1U1 U2U2 14-15

16. Managerial Economics and Organizational Architecture, 5e Employer Preferences for Paying Salary or Fringe Benefits Fringe benefits (in dollars) Salary (in dollars) Isocost curves $ $ 14-16

17. Managerial Economics and Organizational Architecture, 5e The Optimal Mix Salaries Versus Fringes Maximize firm value by meeting potential employee’s reservation utility at lowest cost Indifference curve is tangent to an isocost line 14-17

18. Managerial Economics and Organizational Architecture, 5e Optimal Mix Between Salary and Fringe Benefits S* Salary F*F* Fringe benefits (in dollars) $ U 14-18

19. Managerial Economics and Organizational Architecture, 5e Salary-Fringe Benefit Choice Management should heed to preferences of the employees and offer the benefits they want Employees are willing to tradeoff salary for benefits Must account for taxes on both the firm and employee Be aware of secondary effects –Sick leave may motivate absenteeism 14-19

20. Managerial Economics and Organizational Architecture, 5e Optimal Choice of Salary and Fringe Benefits with Payroll Taxes Salary (in dollars) S* S’ F* F’ Fringe benefits (in dollars) U No payroll taxes Payroll taxes 14-20

21. Managerial Economics and Organizational Architecture, 5e Attracting Particular Types of Employees with the Salary-Benefits Mix Reservation utility: Single person Reservation utility: Married person Fringe benefits (in dollars) Salary (in dollars) $M$M $S$S $ FSFS FMFM $ 14-21