1. Chapter 7: Alternative Pay Schemes and Labor Efficiency
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Chapter 7: Alternative Pay Schemes and Labor Efficiency

2. 1. Economics of Fringe Benefits
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1. Economics of Fringe Benefits

3. Fringe Benefits as a Proportion of Compensation
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Fringe Benefits as a Proportion of Compensation

4. Relative Growth of Fringe Benefits
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Relative Growth of Fringe Benefits

5. 2. Theory of Optimal Fringe Benefits
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2. Theory of Optimal Fringe Benefits

6. Worker Indifference Map
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Worker Indifference Map
The indifference curves show the combinations of wages and fringe benefits that yield the same amount of total utility.
Wages
Fringes benefits are somewhat substitutable for wages even though most fringe benefits are in-kind benefits (benefits for a specific good or service). I3 I2
Workers substitute wages for fringe benefits because wages are taxed, but fringe benefits are not. I1
They also may substitute wages for fringe benefits to insure money is available for health insurance and retirement.
Fringe Benefits

7. Employer’s Isoprofit Curve
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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.
Fringe Benefits
Wages W F
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.
654

8. Wage-Fringe Optimum Wages F W I1 I2 I3 B
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Wage-Fringe Optimum
Fringe Benefits
Wages F W I1 I2 I3 B
The optimal combination of wages and fringe benefits is at B, where the isoprofit curve is tangent to the highest attainable indifference curve (I2).
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 F0 W0 C

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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.
Fringe Benefits
Wages W F F’ I1 I2 A B
This allows the worker to attain a higher indifference curve (I2 rather than I1).
In the process, fringe benefits expand from F0 to F1. W0 F1 F0 W1

10. Causes of Fringe Benefit Growth
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Causes of Fringe Benefit Growth
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.

11. Causes of Fringe Benefit Growth
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Causes of Fringe Benefit Growth
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.

12. Causes of Fringe Benefit Growth
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Causes of Fringe Benefit Growth
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.

13. Questions for Thought:
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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?

14. 3. Principal-Agent Problem
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3. Principal-Agent Problem

15. Principal-Agent Problem
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Principal-Agent Problem
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.

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4. Pay for Performance

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Piece Rates
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.

18. Commissions and Royalties
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Commissions and Royalties
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

19. Raises and Promotions Annual Income
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Raises and Promotions
Leisure
Annual Income L W I1 L1 Y1 A
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. I2 B L2
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.

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Bonuses
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.

21. Bonuses Team performance bonuses Based on team performance.
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Bonuses
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.

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Profit Sharing
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.

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Tournament Pay
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.

24. Highest Paid CEOs, 2002 Name Company Total Pay (millions)
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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
48.6
Robert Kotick
Activision
43.3
Ralph Roberts
Comcast
39.8
Charles Fote
First Data
39.1
Orin Smith
Starbucks
38.8

25. Tournament Pay and CEOs
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Tournament Pay and CEOs
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.

26. Tournament Pay and CEOs
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Tournament Pay and CEOs
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.

27. 5. Efficiency Wage Payments
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5. Efficiency Wage Payments

28. Efficiency Wage Payments
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Efficiency Wage Payments
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.

29. Wage-Productivity Dependency
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Wage-Productivity Dependency
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.

30. Efficiency Wage Theories
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Efficiency Wage Theories
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.

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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. W2 Q1 W1 D1
Quantity of Labor Hours
Wage rate S A D2 B Q2 C
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.

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Criticisms
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.

33. Questions for Thought:
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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.

34. 6. Deferred Payment Schemes
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6. Deferred Payment Schemes

35. Deferred Pay Contracts
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Deferred Pay Contracts
MRP
Quantity of Labor Hours
Wage rate, MRP
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.
Wage
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.
Because of the increased productivity, workers may get higher lifetime earnings than if wages equaled MRP each year.

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Role of Pensions
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.

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Final Points
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.

38. 4/24/2017
End Chapter 7