HRMN 495-Mini Case Study 2

SAGE Reference

The SAGE Handbook of Human Resource Management

Author: Barry Gerhart

Pub. Date: 2010

Product: SAGE Reference

DOI: https://doi.org/10.4135/9780857021496

Keywords: pay for performance, incentives, staff, agency theory, pay, human resource strategy, executive

compensation

Disciplines: Human Resource Management (general), Human Resource Management, Business &

Management

Access Date: March 2, 2023

Publishing Company: SAGE Publications Ltd

City: London

Online ISBN: 9780857021496

© 2010 SAGE Publications Ltd All Rights Reserved.

Retrieved from https://sk-sagepub-com.ezproxy.umgc.edu/reference/hdbk_humanresourcemgmt/ n13.xml

Compensation

Introduction

Across organizations, the single largest operating cost, on average, is employee compensation or remuner-

ation (Blinder, 1990; European Parliament, 1999; US Bureau of Labor Statistics, 2001). Thus, for an organi-

zation to be successful, it must effectively manage not only what it spends on compensation, but also what

it gets in return. Contextual factors serve to place some limits on compensation decisions. Legal, institution-

al (e.g., labor union), cultural, and market (product and labor) contextual factors vary across countries and

often within countries, meaning that the degree of discretion an organization has in managing compensation

decisions will also vary. Nevertheless, organizations typically have at least some discretion in compensation

design.1 This choice can have a major impact at every level of the organization on decisions made by individ-

uals (through its incentive effects), as well as who those individuals are (through its sorting or self-selection

and selection effects). In other words, compensation can be a major factor in successfully executing an orga-

nization's strategy.

Compensation, or remuneration, can be defined and studied in terms of its key decision/design areas, which

include (Gerhart and Milkovich, 1992; Milkovich and Newman, 2008) how pay varies across (and sometimes

within) organizations according to its level (how much?), form (what share is paid in cash versus benefits?),

structure (how pay differentials depend on job content, individual competencies, job level/promotion, and busi-

ness unit?), basis or mix (what is the share of base pay relative to variable pay and what criteria determine

payouts?), and administration (who makes, communicates, and administers pay decisions?).2

I focus here primarily on the pay basis/mix and, to a lesser extent, the pay level, dimensions. I will often refer

to these two decisions, respectively, as the ‘how to pay?’ and ‘how much to pay?’ decisions (Gerhart and

Milkovich, 1992; Gerhart and Rynes, 2003). The reason for the greater focus on the ‘how to pay’ decision is

that it may be the more strategic of the two in terms of the degree to which an organization can differentiate it-

self from others (Gerhart and Milkovich, 1990). Further, in organizations that differentiate their pay levels from

competitors and that are successful over time (in competitive markets), it may be that their pay levels are not

independent of how they pay. For example, an organization with a strong pay-for-performance plan (PFP) is

more likely to have a high pay level when performance is strong.

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I begin with a brief review of theoretical perspectives that help in understanding the potential consequences of

different PFP and pay level decisions. As part of this, I highlight key intervening processes. Finally, I address

potential pitfalls in using PFP and how contextual factors may influence compensation strategy and effective-

ness.3

Effects of Pay

Theoretical Mechanisms

The role of pay, specifically PFP, and its effect on the level and direction of motivation in the workplace has

sometimes been debated and sometimes ignored in the applied psychological literature on motivation. (See

Rynes et al., 2005 for a review, including discussion of theories by Deci, Maslow, and Herzberg.) However,

the facts are that in developed economies, monetary rewards are (a) ubiquitous, (b) a major cost in most or-

ganizations (see above), and (c) as this chapter will help make clear, can have a major impact (positive or

negative) on employee attitudes, choices, and behaviors. Accordingly, in some streams of this literature, it

has been recognized that ‘Money is the crucial incentive’ (Locke et al., 1980: 379) and that ‘the one issue that

should be considered by all organization theories is the relationship between pay and performance’ (Lawler,

1971: 273).

From a psychological perspective, Campbell and Pritchard (1976) observe that motivation can be defined in

terms of its intensity, direction, and persistence. (Together with ability and situational constraints/ opportuni-

ties, motivation contributes to observed behavior.) Thus, to fully evaluate the impact of pay on motivation, one

must look not only at (enduring) effort level, but also the degree to which effort is directed toward desired

objectives.

As Lawler (1971) demonstrates, theories such as reinforcement, expectancy, and equity have deep roots in

psychology. Although compensation research using these theories (with the possible exception of equity the-

ory) is no longer very active, their core ideas provide much of the basis for how scholars and many practition-

ers think of the impact of compensation on employees. A brief review of these theories, as well as the more

economics-based agency and efficiency wage theories follows below. (See Gerhart and Rynes, 2003 for a

more complete review.)

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Reinforcement theory (e.g., Skinner, 1953) is based on Thorndike's Law of Effect, which states that a re-

sponse followed by a reward is more likely to recur in the future. By the same token, a response not followed

by a reward is less likely to recur in the future. These two phenomena are reinforcement and extinction, re-

spectively. A notable feature of Skinner's perspective was his adamant avoidance of cognitive processes in

explaining motivation. In Skinner's view, cognitions were by-products of the central driver of motivation, re-

inforcement contingencies in the environment, and so were not necessary or useful in building a science of

behavior.

Subsequently, however, the field of psychology went through its ‘cognitive revolution,’ which departed from

reinforcement theory by focusing on cognitions such as self-reports of attitudes, goals, subjective probabili-

ties, and values. Later theories such as goal-setting (e.g., Locke), expectancy (e.g., Vroom, 1964), and equity

(Adams, 1963), all give cognitions a central explanatory role. At the same time, they also continue to recog-

nize the importance of reinforcement processes as drivers of those cognitions and later behavior. The po-

tential value of studying cognitions as mediators is that factors other than compensation and incentives may

influence goal choice, effort choice, and behaviors. Measuring cognitions and self-reports may be helpful in

understanding why compensation and incentives do or do not work in a particular situations.

In expectancy theory (Campbell and Pritchard, 1976; Vroom, 1964), behavior is seen as a function of ability

and motivation. In turn, motivation (also referred to as effort or force) is viewed as a function of belief sre-

garding expectancy, instrumentality, and valence. Expectancy is the perceived link between effort and perfor-

mance. Instrumentality is the perceived link between performance and outcomes and valence is the expected

value (positive or negative) of those outcomes. There is often a focus on compensation's effect on instru-

mentality. For example, a strong PFP program is likely to generate stronger beliefs that performance leads

to high pay than would a weak PFP program or a seniority-based pay system. However, motivation can be

undermined not only by weak instrumentality (e.g., weak PFP), but also by weak expectancy (e.g., because

of inadequate selection, training or job design) or valence (outcomes that are negative or not sufficiently pos-

itively valued).

The unique contribution of equity theory (Adams, 1963) to motivation is its focus on social comparison

processes. In essence, it states that how an employee evaluates his/her outcomes from work depends on an

assessment of how his/her ratio or outcomes (e.g., perceived compensation and rewards) to inputs (e.g., per-

ceived effort, qualifications, performance) compares to a comparison standard (e.g., a co-worker or peer in

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another organization). When the ratios are perceived to be equal, equity is perceived and no action (cognitive

or behavioral) is taken to change the situation. However, to the extent the ratios are not perceived as equal,

there is perceived inequity, and action (behavioral or cognitive) is hypothesized to be taken to restore equity

or balance, especially if the inequity is under reward inequity for the focal person (Lawler, 1971).

One reason for focusing on the role of (in) equity is that so many of its potential behavioral consequences

(e.g., effort withholding, turnover, theft, collective action, legal action, renegotiation of terms) are undesirable

to many or all employers. As a practical matter, many employers use attitude surveys to monitor employee eq-

uity perceptions and attitudes in hopes of finding any problems in compensation or other areas early enough

to head off undesired consequences. Not surprisingly, then, leading textbooks in compensation management

(e.g., Milkovich and Newman, 2008) give a central role to the various aspects of pay equity in helping man-

agers understand how employees react to compensation decisions.

Agency theory starts from the observation that once an entrepreneur hires their first employee, there is sep-

aration of ownership and control (Jensen and Meckling, 1976). The entrepreneur (and/or others having own-

ership stakes, as in a larger firm) retains ownership, but now must deal with an agency relationship, under

which the owner (i.e., principal) contracts with one or more employees (i.e., agents) ‘to perform some service

on their behalf which involves delegating some decision making authority to the agent’ (Jensen and Meck-

ling, 1976: 308). The challenge in an agency relationship is that the agent does not necessarily act in the

best interests of the principal, giving rise to agency costs, which specifically arise from goal incongruence (the

principal and agent have different goals) and information asymmetry (the principal has less information than

the agent regarding the value to the principal of the agent's attributes and behaviors).

To control agency costs, the principal must choose a contracting scheme that is behavior-based (pay based

on observation of behaviors) and/or outcome-based (pay based on outcomes/results such as profits, produc-

tivity, shareholder return). The choice depends on factors such as the relative cost of monitoring behaviors

versus outcomes, their relative incentive effects, and the degree of risk aversion among agents. A key issue is

the hypothesized trade-off between incentive intensity and risk. Generally, it is assumed that incentive inten-

sity can be stronger under outcome-based contracts because they are more objective, and thus less subject

to measurement error (Milgrom and Roberts, 1992). On the other hand, employees, who generally rely on

their job as their predominant source of income, are risk averse. Greater incentive intensity is associated, on

average, with greater performance outcome variability (which also may not be entirely under the agent's con-

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trol) and thus, greater compensation risk. Therefore, a compensating differential to the agent for taking on the

greater risk of an outcome-based contract is expected under agency theory. (An implication is that strong in-

centives increase labor cost, meaning that the incentives must drive higher performance to be cost-effective.)

The question is which contract will maximize the gains from incentives, while controlling the costs of shifting

risk to workers (Prendergast, 1999)? Consistent with agency theory, companies having more financial risk

tend to have less risk-sharing/incentive intensity in their compensation for managers and executives (Aggar-

wal and Samwick, 1999; Bloom and Milkovich, 1998; Garen, 1994), with there also being some evidence that

risk-sharing is least likely in very low or very high financial risk situations (Miller et al., 2002). Also consis-

tent with agency theory, as information asymmetries increase, outcome-based contracts are more likely to be

used (Eisenhardt, 1989; Makri et al., 2006; Milkovich et al., 1991).

Although is has been argued that the trade-off between risk and incentives in designing contracts is the main

focus of agency theory (e.g., Aggarwal and Samwick, 1999; Prendergast, 1999), the general focus on con-

tracting in agency theory also suggests an assumption that performance, whether results-based or behavior-

based or both, plays a key role in determining compensation. In economics, while recognizing that agency

costs can compromise the pay-performance relationship, the existence of substantial pay for performance

among executives is generally taken as a given, at least in a country like the US, where stock plans are the

source of most executive wealth creation (Murphy, 1999). However, in other fields (e.g., management), there

is greater skepticism regarding the degree to which executive compensation and performance are related,

with a greater role for power and politics generally being seen. (For a give-and-take on theses issues, see

articles by Bebchuk and Fried, 2006; Conyon et al., 2006. See Devers et al. for a review of recent studies.)

A review and empirical study by Nyberg et al. (2007) suggests that the management literature has underesti-

mated the role of performance, and thus the applicability of agency theory, in determining executive compen-

sation.

Efficiency wage theory seeks to provide an economically rational explanation for why firms have different pay

levels.4 The essential argument is that firms pay high wages either because some aspect of their technology

and/or human resource system requires higher than average quality workers or because monitoring perfor-

mance is more difficult due to information asymmetry (Krueger and Summers, 1998; Yellen, 1984). Paying a

higher than average wage may discourage shirking because the worker at the high-wage firm does not want

to risk losing his/her wage premium (Cappelli and Chauvin, 1991). This effect is expected to be magnified to

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the degree that the risk of job loss increases. The unemployment rate is one indicator of risk of job loss and

Yellen (1984) states that ‘Unemployment plays a valuable role in creating work incentives.’5 Another impli-

cation of efficiency wage theory is that supervision and efficiency wages may be substitutes for one another

(Groshen and Krueger, 1990; Neal, 1993). In other words, shirking can be controlled either by having many

supervisors closely monitoring behaviors or by having fewer supervisors but a higher potential wage penalty if

shirking is observed. Lazear (1979: 1266) states that without an appropriate pay system, workers would have

an ‘incentive to cheat, shirk, and engage in malfeasant behavior.’

Theoretical themes and Intervening Processes

To greatly simplify, one can say that in the above theories, pay operates on motivation and performance in

two general ways (Gerhart and Milkovich, 1992; Gerhart and Rynes, 2003; Lazear, 1986). First, there is the

potential for an incentive effect, defined as the impact of pay on current employees’ motivational state. The

incentive effect is how pay influences individual and aggregate motivation, holding the attributes of the work-

force constant and it has been the focus of the great majority of theory and research in compensation, espe-

cially outside of economics.

Second, there is the potential for a sorting effect, which we define as the impact of pay on performance via its

impact on the attributes of the workforce. Different types of pay systems may cause different types of people

to apply to and stay with an organization (self-select) and these different people may have different levels

of ability or trait-like motivation, or different levels of attributes (e.g., team skills) that enhance effectiveness

more in some organizations than in others. Organizations too may differentially select and retain employees,

depending on the nature of their pay level and/or PFP strategies. The self-selection aspect of sorting and its

application to the effects of pay is based primarily on work in economics (e.g., Lazear, 1986), but the idea

is consistent with Schneider's (1987) attraction-selection-attrition (ASA) idea in the applied psychology litera-

ture. Evidence suggests that the magnitude of ASA processes can be substantial (Schneider et al., 1998).

Together, the sorting and incentive ideas provide one broad conceptual framework for thinking about inter-

vening processes in studying the effects of compensation. Another is the ability-motivation-opportunity to con-

tribute (AMO) framework (Appelbaum et al., 2000, Boxall et al., 2007). Compensation seems most likely to

influence workforce ability and motivation, less likely to come into play in the ‘O’ component, which has more

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to do with job design and participation in decisions. (As noted later, however, the ‘O’ component and the

AMO dimensions in general are quite relevant in addressing horizontal alignment in HR and compensation.)

The impact of compensation on workforce ability is expected to operate primarily through its sorting effects,

but some forms of compensation (for example, skill-based or competency-based pay) can also directly in-

fluence ability via incentive effects. Management development over time via different job assignments and

experiences (especially those involving upward mobility) is also typically supported by compensation systems

through promotion incentives (sometimes described as tournament systems). Other incentive effects, such as

motivation and effort on the current job, are perhaps more straightforward.

Gerhart and Milkovich (1992) called for compensation research to include intervening variables (and) at ‘mul-

tiple levels’ of analysis in studying compensation and performance, because ‘if a link is found … possible

mediating mechanisms can be examined to help establish why the link exists and whether (or which) causal

interpretation is warranted’ (p. 533). Beyond the general mediating mechanisms discussed above, more de-

tailed intervening variables might include employee attitudes, individual performance and/or competencies,

and employee turnover (broken out by performance levels). Other relevant mediators, depending on the par-

ticular goals of the unit or organization, would be citizenship behavior, teamwork, climate for innovation, mo-

tivation, and engagement. Note that while HR practices such as compensation might be thought of as op-

erating at the level of the organization or work unit, the mediators discussed here are often conceptualized

as individual level processes. Therefore, models (e.g., hierarchical linear modeling, Raudenbush and Bryk,

2002) designed to handle multiple levels may prove useful in empirical work addressing this type of mediaton.

A final mediator that is perhaps obvious, but nevertheless sometimes ignored in research (as opposed to

practice) is cost. Higher pay levels and/or higher staffing levels drive up labor costs. In addition, according to

agency theory, incentive intensity, because it shifts risk to workers, is also expected to drive up pay levels by

requiring a compensating differential for risk. We address the cost issue more fully below.

Effects of Pay Level

Although competitive pressures drive firms to minimize costs and maximize benefits, the cost side means

that, in the absence of higher productivity, quality, superior products development, customer responsiveness

and so forth, firms must keep total labor costs in line with those of competitors by controlling total compen-

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sation per employee and/or by controlling employee headcount. In a global world, cost control includes an

ongoing search for the lowest cost location for production, all else being equal (e.g., proximity to customers

and suppliers, worker skill levels) which is to varying degrees, depending on the product, technology, and

work organization, a partial function of labor costs. As Table 13.1 makes clear, labor costs differ significantly

across the world. (What Table 13.1 does not show is that labor costs also vary across companies within many

countries.)

As noted previously, efficiency wage theory suggests that higher wages may have positive sorting and in-

centive effects. More specifically, the observable benefits of higher wages may include (Gerhart and Rynes,

2003): higher pay satisfaction (Currall et al., 2005; Williams et al., 2006; for a review, see Heneman and

Judge, 2000), improved attraction and retention of employees (for a review, see Barber and Bretz, 2000), and

higher quality, effort, and/or performance (e.g., Yellen, 1984; Klass and McClendon, 1996).

Table 13.1 Average hourly labor costs for manufacturing production workers, by country (US dollars), 2005

United States 24

Canada 24

Germany 33

France 25

United Kingdom 26

Spain 18

Czech Republic 6

Japan 22

Mexico 3

Hong Konga 6

Korea 14

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Note:Wage rates rounded to nearest dollar except when rate is less than one dollar.

Sources: US Bureau of Labor Statistics, http://www.bls.gov; Banister, J. (2005)

a Special Administrative Region of China

b 2004

c 2002.

In discussing pay level from a public policy perspective, a distinction is sometimes made between ‘low road’

(low pay level) versus ‘high road’ (high pay level) human resource systems (Gerhart, 2007).6 Using the AMO

model, a ‘high road’ policy typically combines higher (‘efficiency’) wages with high levels of worker responsi-

bility and autonomy and often team-based work (O), all of which may require a higher quality workforce (A).

To the extent that the high road HR system is costly, due to not only high wages but also high investment

in AMO areas broadly, it may not align typically as well with a cost leadership business strategy as would a

less costly, low road strategy. Historically, this is perhaps most readily seen in the way that firms often move

low skill work offshore to locations where it can be done much more cheaply. More recently, there has been

a great deal of attention given to the movement of skilled work (e.g., writing computer code; tax preparation)

offshore to less expensive locations. We return later to the question of under what circumstances a high road,

high pay level strategy is most likely effective.

Cost is an outcome that has been explicitly recognized and quantified in cost-benefit models such as utility

analysis (Brogden, 1949; Boudreau, 1991), but the application of utility analysis to compensation, with explicit

attention to not only its benefits, but also the costs of pay programs, has been surprisingly rare (Klaas and

McCledon, 1996; Sturman et al., 2003; Gerhart and Rynes, 2003). This is ironic because, inside of organiza-

tions, it often seems to be cost that gets the lion's share of attention. Cappelli and Neumark (2001) observe

this same omission in much of the broader literature on the effectiveness of HR systems. Indeed, they inter-

pret their findings as indicating that high road HR systems ‘raise labor costs … but the net effect on overall

profitability is unclear’ (p. 766).

I conclude the discussion of pay level at this point because the pay level decision is one that is (or should be)

made in tandem with the how to pay decision (Gerhart and Rynes, 2003). For example, any organization op-

erating in a competitive market will have difficulty being successful over time with a high pay level that is not

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paired with high performance at the individual and organizational level. Thus, the how to pay or PFP decision.

Effects of Pay for Performance (PFP)

Types of PFP programs include profit sharing, stock plans, gainsharing, individual incentives, sales commis-

sions, and merit pay (Milkovich and Newman, 2008). As Table 13.2 shows, these programs can be classified

on two dimensions (Milkovich and Wigdor, 1991): level of measurement of performance (e.g., individual, plant,

organization) and type of performance measure (results-oriented or behavior-oriented). It is important to note

that, in practice, many employees are covered by hybrid pay programs (e.g., a combination of merit pay and

profit sharing).

US companies well-known for their use of PFP include Lincoln Electric, Nucor Steel, Whole Foods, Hewlett-

Packard, Southwest Airlines, and General Electric, to name just a few. Each uses a different form of PFP, with

varying degrees of relative emphasis on individual, group/unit, and/or organization level performance. Out-

side the US, in countries with less of a tradition of PFP, there appears to be a movement in some cases (e.g.,

Japan, Korea) toward greater emphasis on PFP at all organization levels. In these and many other countries,

there has been a clear movement toward greater use of PFP for selected employee groups (e.g., executives),

(Towers Perrin, 2006).

Incentive Effects

In a meta-analysis of potential productivity-enhancing interventions in actual work settings, Locke et al. (1980)

found that the introduction of individual pay incentives increased productivity by an average of 30%.7 This

finding was based on studies that were conducted in real organizations (as opposed to laboratories), used

either control groups or before-and-after designs, and measured performance via ‘hard’ criteria (e.g., physical

output) rather than supervisory ratings.

Subsequent research also supports the powerful incentive effects of pay. A meta-analysis by Guzzo et al.

(1985) found that financial incentives had a large mean effect on productivity (d = 2.12).8 More recent meta-

analyses (Jenkins et al., 1998; Judiesch, 1994; Stajkovic and Luthans, 1997) likewise provide strong support

for a significant positive relationship between financial rewards and performance.

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There has also been research on plans using collective performance, including gain-sharing, profit sharing,

and stock plans. (For reviews, see Gerhart and Milkovich, 1992; Gerhart and Rynes, 2003.) Without delving

into the specific findings of this literature, a few general observations are in order. First, whereas most of the

individual level research follows the same people over time, thus probably yielding what are essentially incen-

tive effects, studies of plans using collective performance as the dependent variable do not usually hold the

workforce constant as the design often involves between-company and/or longitudinal tracking of companies.

Thus, it is difficult to separate incentive and sorting effects. Second, the set of relevant determinants of col-

lective performance (e.g., profitability) is perhaps larger than in the typical study of individual incentive plans.

Again, this makes it more of a challenge to isolate the impact of compensation relative to other factors.

In studies of executives, keeping in mind that some of these same challenges apply (given that performance

is usually defined as firm-level performance), evidence suggests that PFP plan design may influence a wide

range of strategic decisions (Gerhart, 2000), including staffing patterns, diversification, research and devel-

opment investment, capital investment, and reaction to takeover attempts. Likewise, over time, organizational

strategy is more likely to change when (executive) pay strategy changes (Carpenter, 2000). Thus, there is

consistent evidence that pay strategy does influence managerial goal choice.

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Sorting Effects

After reading the studies reviewed above, the reader would be well aware of the incentive mechanism, but

quite possibly unaware of the sorting mechanism as a possible explanation for the observed effects. As not-

ed, to the extent the above studies track the same individuals before and after the intervention, they do in-

deed estimate incentive effects. However, to the degree the individuals making up the workforce changed in

response to a PFP intervention, then at least some of the improvement in performance might be due to a

sorting effect. Lazear (2000), for example, reported a 44% increase in productivity when a glass installation

company switched from salaries to individual incentives. Of this increase, roughly 50% was due to existing

workers increasing their productivity, while the other 50% was attributable to less productive workers quitting

and being replaced by more productive workers over time.

Cadsby et al. (2007) likewise found that both incentive and sorting effects explained the positive impact of

PFP on productivity. Their study, set in the laboratory, was designed so that subjects went through multiple

rounds. In some rounds, subjects were assigned to a PFP plan, while in other rounds they were assigned to

work under a fixed salary plan. In yet other rounds, they were asked to choose either the fixed salary or the

PFP plan to work under (i.e., they were asked to self-select). Cadsby et al. found that by the last rounds in

their experiment, the PFP condition generated 38% higher performance than the fixed salary condition and

that the sorting effect (less risk averse and more productive subjects being more likely to select the PFP con-

dition) was actually about twice as large as the incentive effect in accounting for this 38% difference. In ex-

plaining why they found a sorting effect that was larger than that found by Lazear (which was also substantial),

Cadsby et al. observe that in the Lazear study, few employees chose to leave the organization, presumably

because there was no downside risk to the PFPplan implemented there. Thus, most of the sorting effect in

the Lazear study was probably attributable to new hires being more productive than current employees on av-

erage, without much of the sorting effect being due to lower performing employees leaving the organization.

Evidence suggests that PFP is more attractive to higher performers than to lower performers. For example,

Trank and her colleagues (2002) found that the highest-achieving college students place considerably more

importance on being paid for performance than do their lesser-achieving counterparts. Likewise, persons with

higher need for achievement (Bretz et al., 1989; Turban and Keon, 1993), and lower risk aversion (Cadsby

et al., 2007; Cable and Judge, 1994) also prefer jobs where pay is linked more closely to performance. Since

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these are all characteristics that some or most employers desire, such individual differences are important

for employers to keep in mind. Other research shows that high performers are most likely to quit and seek

other employment if their performance is not sufficiently recognized with financial rewards (Salamin and Hom,

2005; Trevor et al., 1997). Conversely, low performers are more likely to stay with an employer when pay-per-

formance relationships are weaker (Harrison et al., 1996).

Finally, to the degree that sorting effects are important, they may make it appear as though the relationship

between pay and performance is weaker than it really is (Gerhart and Rynes, 2003). For example, to the

degree that organizations are selective and valid in their decisions regarding who to hire and who to retain,

the remaining group of employees will be unrepresentative in that their average performance level should in-

crease as selectivity and validity increase (Boudreau and Berger, 1985). So, even if there is little observed

variance in performance and/or pay within this group (i.e., there is range restriction), this selected group of

employees may have above market pay and above market performance. Thus, in this example, there is no

(observed) relationship between pay and performance within the firm, but there would be a significant rela-

tionship between pay and performance between firms. Similarly, on the employee side of the decision, it may

be that high performers self-select such that they are more likely to join and remain with organizations that

have PFP. In summary, even when there is little observed variance in performance ratings and/or pay within

an organization, it may nevertheless be the case that PFP, via sorting effects, have resulted in major differ-

ences in performance between organizations.

The Challenge of Defining and Measuring Performance

A limitation of the meta-analytic evidence reviewed earlier on the effects of PFPis that in most of the included

studies, physical output measures of performance (e.g., number of index cards sorted, number of trees plant-

ed) were available, (and related to this) tasks were simple, and individual contributions were usually separa-

ble (Gerhart and Rynes, 2003).

In contrast, in many jobs, some or all of these three characteristics do not apply (Lawler, 1971). The wide-

spread use of merit pay and its subjective performance measures, is to an extent, a result of this fact

(Milkovich and Wigdor, 1991). While this mismatch is recognized in the applied psychology literature, there

remains little work that uses strong research designs to study more widely used individual-oriented PFP plans

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such as merit pay (Heneman, 1992) or hybrids of different PFP programs (Gerhart and Rynes, 2003). The

economics literature is also coming to grips with the performance measurement challenge, acknowledging

that there has been a tendency in discussions of incentives to assume that performance can be ‘easily mea-

sured’ (Gibbons, 1998: 118) and that, as a result, ‘economists have tended to place excessive focus on the

contracts of workers for whom output measures are easily observed’ despite the fact that ‘most people don't

work in jobs like these’ (Prendergast, 1999: 57).

Returning to Table 13.2, recall that performance measures vary in at least two respects. First, as emphasized

in agency theory, they can be results-oriented (e.g., number of units produced) behavior-oriented (e.g., su-

pervisory evaluations of effort or quality)? Second, performance can focus on individual or collective contribu-

tions.

Among the potential advantages of behavior-oriented measures are that they (Gerhart, 2000), can be used for

any type of job, permit the rater to factor in variables that are not under the employee's control (but that nev-

ertheless influence performance), thus reducing the risk-sharing concerns identified in agency theory. They

also allow a focus on whether results are achieved using acceptable means and behaviors, carry less risk

of measurement deficiency, or the possibility that employees will focus only on explicitly measured tasks or

results at the expense of other objectives. On the other hand, the subjectivity/measurement error of behav-

ior-oriented measures (for a review, see Viswesvaran et al., 1996) can make it more difficult for organizations

to justify differentiating between employees (Milkovich and Wigdor, 1991) using stronger incentive intensity

(Milgrom and Roberts, 1992), unless steps are taken to improve reliability and credibility (e.g., using multiple

raters, Viswesvaran et al., 1996). Managers may also have disincentives to differentiate (Murphy and Cleve-

land, 1995).

Results-oriented measures (e.g., productivity, sales volume, shareholder return, profitability), while more ob-

jective and thus often more credible to employees as a basis for differentiation, and thus more typically used

to provide more powerful incentives, also have potential drawbacks. As noted, relevant objective measures

are not available for most jobs, especially at the individual level. Moreover, as also noted, agency theory em-

phasizes that results-based plans (e.g., individual incentives, gainsharing, profit-sharing) increase risk-bear-

ing among employees (Gibbons, 1998). Poor performance on such measures (and thus decreasing or dis-

appearing payouts), especially if attributed to factors employees see as beyond their own control (e.g., poor

decisions by top executives), tend to result in negative employee reactions, often resulting in pressure to ei-

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ther revise the plan in a way that weakens incentives (Gerhart, 2001) or to abandon the plan (e.g., Petty et al.,

1992). Finally, narrowly defined results-oriented measures may result in some aspects of performance being

ignored and undesirable means used to maximize incentive payouts.

Performance measures also vary according to whether they emphasize individual or group (or collective) per-

formance. Incentive effects (in terms of instrumentality perceptions) are generally stronger under individual

performance plans (Schwab, 1973). Also, positive sorting effects may be realized as the most productive and

achievement-oriented employees appear to prefer or gravitate to such plans (e.g., Bretz et al., 1989; Lazear,

1986; Trank et al., 2002; Trevor et al., 1997). On the other hand, too much focus on individual performance

may undermine cooperation and teamwork, which are widely viewed as increasingly important in gaining com-

petitive advantage through people (Deming, 1986; Pfeffer, 1998).

However, using group-based incentives creates other challenges, not only with respect to sorting effects, but

also incentive effects, especially in anything but small groups: ‘Unless the number of individuals in a group is

quite small, or unless there is coercion or some other special device to make individuals act in their common

interest, rational self-interested individuals will not act to achieve their common or group interests’ (Olson,

1965: 1–2, emphasis in the original). Theory and research across fields (e.g., variously described as the com-

mon-resource problem, public-goods problem, free-rider problem, or social loafing problem) has identified a

fundamental challenge in using group incentives (Gerhart and Rynes, 2003; Kidwell and Bennett, 1993); when

people share the obligation to provide a resource (e.g., effort), it will be undersupplied because the residual

returns (e.g., profit sharing payouts) to the effort are often shared relatively equally, rather than distributed in

proportion to contributions.

In summary, performance measures must have a meaningful link to what the organization is trying to accom-

plish, be sufficiently inclusive of key aspects of performance, balance sometimes competing objectives, and

be seen as fair and credible by employees. Organizations often attempt to achieve these goals by using multi-

ple measures of performance, aggregate and individual, results and behavior-oriented (e.g., as in a Balanced

Scorecard), and adjusting incentive intensity, to an important extent, based on the degree to which valid and

credible performance measurement is believed to be achievable. The main constraint on using multiple mea-

sures is the complexity introduced and the risk that this will work against employees' understanding of the

plan and, thus, their motivation. Indeed, even among executives, understanding and the perceived value of

stock options appears to diverge from that provided by standard financial models (Devers et al., 2007).

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Cautions and Pitfalls

Any discussion of PFP ‘must consider whether the potential for impressive gains in performance’ from such

plans is ‘likely to outweigh the potential problems, which can be serious’ (Gerhart, 2001: 222). Indeed, using

such plans, perhaps especially so when combined with strong incentive intensity, has been described as ‘a

high risk, high reward strategy’ (Gerhart et al., 1996: 222).

Of course, there are risks in choosing a high pay level as well, especially if it's not linked to high performance.

In a global world, contracts (implicit or explicit) between organizations and employees that were once good for

both may no longer beviable for one or both parties. This change may occur over time (e.g., the automobile

industry in the US and Europe), leading to either changes in the employment contract (lower wages/benefits

and/or more productivity/flexibility in tasks/hours) or a change in the location of production to a lower-cost part

of the country or the world. In the absence of either or both changes in response to changing competitive

conditions, market share and profitability, and ultimately survival, are put at risk.

Returning to the risks in using PFP, several issues can come into play. First, PFP may not be implemented

with sufficient strength. It may exist as a stated policy, but not as a meaningful practice experienced by em-

ployees. Even where (e.g., in the United States) most private sector organizations tend to claim that they

have PFP policies (or researchers claim that they are studying PFP policies), there is, in fact, sometimes

little meaningful empirical relationship between pay and performance (Gerhart and Milkovich, 1992; Gerhart

and Rynes, 2003; Trevor et al., 1997). In the case of merit pay, for example, two factors that often weaken

its strength are lack of differentiation in performance ratings and lack of differentiation in pay increases even

when performance ratings do vary. Not surprisingly then, when employees are asked about how much PFP

there is in their own organizations, they tend to say ‘not very much.’ In a survey of employees in 335 com-

panies conducted by the Hay Group (2002), employees were asked whether they agreed with the statement,

‘If my performance improves, I will receive better compensation’. Only 35% agreed, whereas 27% neither

agreed nor disagreed, and 38% disagreed with this statement.

A second potential problem, somewhat ironically, is that the implementation of PFP may sometimes ‘work’

too well. Here, the danger is that a PFP program can act as a blunt instrument that may result in unintended

and harmful consequences. Successful organizations must balance multiple objectives (e.g., customer rela-

tionships and long-term earnings against short-term opportunistic earnings). In designing an incentive plan

to support this balance, it must be kept in mind that people tend to do what is rewarded and objectives not

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rewarded tend to be ignored. Lawler (1971: 171) warned that ‘it is quite difficult to establish criteria that are

both measurable quantitatively and inclusive of all the important job behaviors,’ and ‘if an employee is not

evaluated in terms of an activity, he will not be motivated to perform it.’ Based on their laboratory study, Wright

et al. (1993) concluded that ‘When individuals are committed to difficult goals, they may strive to achieve

these goals at the expense of the performance of other behaviors that are necessary for organizational effec-

tiveness' (p. 129). Prendergast (1999: 8) likewise argues that ‘Contracts offering incentives can give rise to

dysfunctional behavioral responses, whereby agents emphasize only those aspects of performance that are

rewarded.’ Milgrom and Roberts (1992: 228) refer to this as the equal compensation principle: ‘If an employ-

ee's allocation of time or attention between two different activities cannot be monitored by the employer, then

either the marginal rates of return to the employee must be equal, or the activity with the lower marginal rate

of return receives no time or attention.’

How long a PFP plan remains in place is sometimes used as a measure of its success. While a short-term

gain in performance from a pay plan that does not last long should not be dismissed, it is nevertheless useful

to keep in mind that, in a fair number of cases, such plans do not last long (Gerhart et al., 1996). For example,

Beer and Cannon's analysis (2004) of 13 PFP ‘experiments’ conducted at Hewlett-Packard in the mid-1990s

found that, in 12 of the 13 cases, the program did not survive.

All else equal, a plan that generates longer-term performance gains is preferred and changing plans too

often can result in a counterproductive ‘flavor-of-the-month’ perception among employees (Beer and Cannon,

2004). Data on survival rates is also important for drawing statistical conclusions (Gerhart et al., 1996). Plans

that survive for short periods are more likely to be excluded from studies of pay plan effectiveness, thus re-

sulting in the plans included in the sample looking more effective than they really are in the full population.

While the risks of PFP programs must be acknowledged and understood, the ‘high reward’ aspect of ‘high

risk, high reward’ means that not making sufficient use of PFP can put an organization at risk in a different

way in terms of its competitiveness. Second, PFP programs can be one critical piece in a strategy to change

the culture of an organization, especially if there is sufficient hiring and turnover to allow sorting effects to

change workforce composition. In the case of a start-up company or location, PFP and other aspects of com-

pensation and HR can be used to set the cultural tone and achieve fit from the beginning.

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Alignment and Contextual Factors

In view of the challenges in designing and implementing PFP plans, it is useful to consider how contextual

factors might affect whether a PFP plan is likely to be successful. The preceding discussion regarding chal-

lenges in measuring performance has begun to take us down that path. A further discussion of contextual

factors and alignment follows below.

Alignment

Terms such as alignment, synergy, fit, and complimentarity describe the idea that the effects of two or more

factors are non additive and dependent on contextual factors.9 According to Milgrom and Roberts (1992:

108): ‘Several activities are mutually complementary if doing more of any activity increases (or at least does

not decrease) the marginal profitability of any other activity in the group’ (p. 108). They then propose a more

string ent definition: ‘a group of activities is strongly complementary when raising the levels of a subset of

activities in the group greatly increases the returns to raising the levels of the other activities’ (p. 109). An

example given by Gerhart and Rynes (2003) is where a gainsharing program alone results in an average per-

formance increase of 10%, while a suggestion system alone results in an average performance increase of

10%. However, when used in combination, their total effect is not additive (i.e., 20%), but is rather non-addi-

tive (e.g., 30%). So, the effect of the gainsharing program is contingent on a contextual factor, in this case,

another aspect of HR (Gerhart and Rynes, 2003).

There are two general classes of contingency factors: person and situation. Our earlier discussion of sorting

effects highlighted some of the relevant person factors (e.g., risk aversion, need for achievement, academic

performance) that predict preference for PFP. In addition, other person characteristics may predict prefer-

ences for particular types of PFP. For example, Cable and Judge (1994) found that individual-based PFP was

preferred, on average, by those with high self-efficacy, but as might be expected, less preferred, on average,

by those scoring high on collectivism.

There are three key aspects of pay strategy alignment or fit that focus on the situation or environmental

context (Gerhart, 2000; Gerhart and Rynes, 2003): horizontal alignment (between pay strategy and other di-

mensions of HR management, as in the gain-sharing example above), vertical alignment with organizational

strategy (i.e., corporate and business strategy), and internal alignment between different dimensions of pay

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strategy (e.g., pay level and pay basis). Only a brief review is provided here. (For more detail, see Gerhart,

2000; Gerhart and Rynes, 2003; Gomez-Mejia and Balkin, 1992; Milkovich, 1988).

The primary focus of the pay strategy literature has been on vertical alignment. Aspects of corporate strategy

such as the process, degree and type of diversification (Kerr, 1985; Gomez-Mejia, 1992; Pitts, 1976) and the

firm's life cycle (e.g., growth, maintenance), (Ellig, 1981) are associated with different compensation strate-

gies (Gomez-Mejia and Balkin, 1992; Kroumova and Sesis, 2006; Yanadori and Marler, 2006). Evidence also

suggests performance differences based on fit such that growth firms do perform better with an incentive-

based strategy (Balkin and Gomez-Mejia, 1987) and that the effectiveness of an incentive-based strategy

depends to a degree on the level of diversification (Gomez-Mejia, 1992). Alignment of pay strategy with busi-

ness strategy (e.g., Porter, 1985; Miles and Snow, 1978) may also have performance consequences (e.g.,

Rajagopolan, 1996). Another developing stream of work on non-executives at the business unit level focuses

on the alignment between pay strategy and manufacturing strategy (Shawetal., 2002; Snell and Dean, 1994).

Finally, as noted previously, consistent with agency theory, companies having more financial risk tend to have

less risk-sharing in their compensation for managers and executives (Aggarwal and Samwick, 1999; Bloom

and Milkovich, 1998; Garen, 1994). Thus, both the risk aversion of the individual and risk properties of the

situation are relevant (Wiseman et al., 2000).

Turning to the role of pay level in vertical alignment, as noted earlier, the potential benefits of high wages may

be more important in some firms than in others. Higher pay levels, either for the organization as a whole or for

critical jobs, may be well-suited to particular strategies, such as higher value-added customer segments. The

key work recognizing that firms differ in their choice of low road versus high road HR systems, even within

narrow industries, has been conducted by Hunter (2000) in health care and Batt (2001) in telecommunica-

tions. Batt, for example, reported that firms having a focus on large-business customers paid 68% higher than

firms with no dominant customer focus and that most of this higher pay was due to hiring workers with higher

levels of human capital. Similarly, evidence suggests that organizations making greater use of so-called high

performance work practices (teams, quality circles, total quality management, job rotation) also pay higher

wages (Osterman, 2006).

Boxall and Purcell (2003: 68) provide a nice summary, which only needs to be amended with the important

observation that, as we have just seen, the value-added created may differ within sectors according to firm

differences in strategy:

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Overall, research suggests that the sort of HR practices that foster high commitment from talented

employees are most popular in those sectors where quality is a major competitive factor and where

firms need to exploit advanced technology (as in complex manufacturing) or engage in a highly

skilled interaction with clients (as in professional services). In these sorts of higher value-added sec-

tors, firms need more competence and loyalty from their employees and are more able to pay for

them. In sectors where these conditions are not met—where output per employee is not high—em-

ployers adopt more modest employment policies.

In contrast to the work on vertical alignment, horizontal alignment of pay strategy with other employment prac-

tices has been studied, mostly using non-executive employees and mostly in the context of work on so-called

high-performance work systems and HR systems. The effect of an HR system on effectiveness is thought to

operate, as noted earlier, via the intervening variables of ability, motivation, and opportunity, or AMO (Appel-

baum et al., 2000; Batt, 2002; Boxall and Purcell, 2003; Gerhart, 2007). One problem with studying horizontal

fit, however, is that the hypothesized role of pay and/or PFP, as well as the way these constructs are oper-

ationalized, tends to differ across studies, making it difficult to draw robust conclusions about what other HR

strategy elements work best with particular pay and PFP approaches (Becker and Gerhart, 1996; Gerhart and

Rynes, 2003).

Nevertheless, certain potential areas of fit and mis-fit can be identified (Gerhart and Rynes, 2003; Rynes et

al., 2005). For instance, with respect to the ‘O’ component, it seems likely that group-based incentive plans

(e.g., gainsharing, profit sharing, stock options) will be more effective in smaller groups (Kaufman, 1992;

Kruse, 1993) than in larger groups or organizations. In addition, in situations where work is more interdepen-

dent, it may be that some shift in emphasis from individual performance to group performance will be more

effective (e.g., Shaw et al., 2002). Nevertheless, it must be kept in mind that even where tasks are interde-

pendent, if there are individual differences in ability and/or performance that are important, then placing too

little weight on individual performance in compensation can lead to undesired sorting effects, such that high

performers may not join or remain with the group or organization.

The issue of horizontal alignment can also be approached more broadly. Although compensation is extremely

important in motivation and effectiveness, it is important to continue to keep in mind that compensation is part

of a broader employment relationship, broader than some of the contract notions we have discussed, which

center on the compensation aspect. The literature on HR systems (e.g., the AMO framework) conveys this

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broader view as does work on psychological contracts (e.g, Rousseau and Ho, 2000; Tsui et al., 1997). Like-

wise, earlier work by Herbert Simon (1957), for example, viewed employment as a relationship where mutual

(longer-term) obligations on the part of the employee and employer could be efficient. The hope is that an

organization will obtain the ‘consummate cooperation’ of employees, ‘an affirmative job attitude [that] includes

the use of judgment, filling gaps, and taking initiative’ (Williamson et al., 1975: 266). Organizations often seek

to support this objective through employee ownership. For example, roughly one-half of the publicly traded

companies on the 100 Best Companies to Work For list offer stock options to all or nearly all employees (For-

tune, 1999: 126).

The third area of fit, internal alignment, has been the least studied. The work of Gomez-Mejia and Balkin

(1992) has sought to identify overarching compensation strategies, but more work is needed to document

which aspects of pay tend to cluster together in organizations and whether certain clusters are more effective

and/or what contingency factors are most important. In any event, the modest evidence that exists concern-

ing the degree of actual alignment between pay and other HR strategy dimensions suggests that there is less

alignment than one might wish (Wright et al., 2001).

Although it could be included as a part of vertical alignment, another type of alignment that is important is that

between pay strategy and country. Countries differ on a multitude of dimensions that can affect management

practice (Dowling et al., forthcoming), including the regulatory environment (e.g., requirements for worker par-

ticipation in firm governance), institutional environment (e.g., strength of labor unions, accepted HR practices

in areas like compensation), and cultural values (e.g., Hofstede's (1980) dimensions of individualism/collec-

tivism, long-term orientation, masculinity-femininity, power distance, and uncertainty avoidance). As such, a

good deal of attention has been devoted to the constraints that organizations face when it comes to choosing

which HR and pay strategies (a) can be implemented, and (b) if able to be implemented, which will be effec-

tive. Thus, organizations must decide how best to balance standardization and localization in designing HR

and pay practices.

While practices that are effective in one country are not necessarily going to be effective or even feasible in

another country (due, for example, to legal or strong institutionalized traditions) one should be careful not to

give too much weight to contingency factors generally, including country. For example, in the case of the five

cultural values dimensions made famous by Hofstede (1980, 2001), evidence shows that country actually ex-

plains only a small percentage of variance in individual employee cultural values (Gerhart and Fang, 2005).

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There is good reason to believe that organizations have considerable room to be different from the country

norm in many countries in at least some key areas of HR (Gerhart and Fang, 2005) and pay strategy (Bloom

and Milkovich, 1999).

Also, country norms as they relate to HR and pay strategy can and do change. As mentioned earlier, one

example, is executive compensation. Countries like Germany, South Korea, and Japan changed from essen-

tially no use of long-term incentives (e.g., stock options, stock grants) for top executives in 1998 to substantial

use by 2005 (Towers Perrin, 2006). Another example mentioned earlier is the significant change in South

Korea (Choi, 2004) and in Japan (Morris et al., 2006; Jung and Cheon, 2006; Robinson and Shimizu, 2006)

away from seniority-based pay toward PFP. A third example is the dramatic decline in private sector unionism

in the United States, which stands at 7.4% of the workforce in 2006. A fourth example is the decentraliza-

tion (e.g., from industry to firm or plant level) of collective bargaining in many parts of the world (Katz et al.,

2004). Finally, in their multi-country study, Katz and Darbishire (2002) highlight what they call ‘converging di-

vergences,’ to indicate that there is a set of multiple employment/HR system models shared across countries,

with the multiple and different models existing in each country to varying degrees.

Thus, it is important to recognize not only institutional pressures toward conformity in a country, but also that,

at least in some respects, depending on the country, the timeframe, and the particular policy, there can be

room to be unique and the strategy literature tells us that being the same as everyone else is unlikely to

generate anything more than competitive parity, whereas being different, while perhaps being more risk, has

the potential to generate sustained competitive advantage (e.g., the resource based view of the firm; Barney,

1991). Some work has been done addressing how the RBV is relevant to HR strategy broadly (Becker and

Gerhart, 1996; Colbert, 2004; Barney and Wright, 1998), but beyond Gerhart et al. (1996) there has not been

much application to pay strategy.

Turning to methodology, a challenge in studying contextual or contingent effects is that if only firms and units

that achieve some minimal level of alignment survive (Hannan and Freeman, 1977), alignment may be so

important that it is almost impossible for the researcher to observe substantial departures from alignment

(Gerhart et al., 1996; Gerhart and Rynes, 2003). In this case, restricted range in alignment would reduce the

statistical power available to observe a relationship between alignment and performance. This may help ex-

plain why the idea of fit, while often thought to be critical, has not received as strong support as might be

expected in HR research broadly and in the area of compensation, specifically (Gerhart et al., 1996; Gerhart,

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2007; Wright and Sherman, 1999).

Finally, although fit is typically seen as an important goal, this should perhaps be tempered by the possibility

that fit can be a double-edged sword when it comes to compensation and HR systems. Gerhart et al. (1996)

pointed out that the system (and resulting workforce) that fits the current business strategy may quickly be-

come a poor fit if the business strategy changes. A less tightly aligned set of HR practices, where bets were

hedged, might make a successful adaptation more likely. As Boxall and Purcell (2003: 56) put it: ‘In a chang-

ing environment, there is always a strategic tension between performing in the present context and preparing

for the future.’ Perhaps in recognition of the limitations of static vertical fit, some recent work on HR systems

emphasizes the importance of agility in HR systems and strategy (Dyer and Shafer, 1999) and relatedly, of

flexibility (Wright and Snell, 1998), or what might be seen as a capability for achieving dynamic fit. As a key

part of an HR system, compensation must then be evaluated on an ongoing basis to consider its contribution

to flexibility. Some examples of compensation programs that are seen as promoting flexibility are skill-based

and competency-based pay, as well as broadbands (in place of more detailed pay grades).

Conclusion

Compensation involves decisions in multiple areas. My focus in this chapter has been on PFP and, to a lesser

extent, pay level. I provided an overview of some of the most important theoretical approaches in under-

standing the potential impact of compensation decisions on performance. I have highlighted the potential for

well-designed PFP plans to make a substantial contribution to organization performance through effects on

intervening mechanisms such as incentive and sorting. I have also noted the potential for PFP plans to cause

serious problems, often as a result of unintended consequences. To an important extent, these unintended

consequences stem from the difficulty in specifying and measuring performance, a challenge that is perhaps

often overlooked and/or underestimated in the literature on PFP.

I suggested that the probability of success of PFP plans might be improved by effective alignment with con-

textual factors such as organization and human resource strategy. However, no matter how well thought-out

and planned, the fact remains that the stronger the incentive intensity, the greater not only their potential pos-

itive impact, but also their potential to have a negative impact. At the same time, the risk of having strong

incentives must be balanced against the risk that using weaker incentives will miss the opportunity to help

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drive stronger performance. In closing, I note that firms achieve success by taking different paths, which vary

both in terms of how much they pay and how they pay, including how strong incentives they use.

Notes

1 Even in an environment where there is little discretion in compensation policy and practice (e.g., because

of legal and institutional forces within a particular country), an organization can often obtain greater discretion

by expanding its business in a different environment (e.g., a different industry, a different country, etc.) that

permits greater discretion in policy and practice.

2 Benefits represent a substantial share of compensation cost to employers in the US, for example, given that

many (especially larger) companies fund retirement and health care for employees.

3 Compensation can be defined to include non-monetary rewards as well. Both monetary and non-monetary

rewards are important in the workplace. For a review of the importance of monetary and non-monetary re-

wards in the workplace, see Rynes et al. (2004). However, monetary compensation is unique among rewards

in the following respects (Gerhart and Rynes, 2003; Lawler, 1971; Rottenberg, 1956). First, compensation is

one of the most visible aspects of a job to both current employees and job seekers. Second, unlike some

other job characteristics (e.g., job responsibility, working in teams), most people prefer more money to less.

Third, money can be instrumental for meeting a wide array of needs, including economic consumption, self-

esteem, status, and feedback regarding achievement. Given the central importance of monetary compensa-

tion, as well as limits on what can be covered in a single chapter, the main focus here is on pay or monetary

rewards.

4 A strict, traditional, neoclassical economics view would find the notion that employers (at least within a par-

ticular market) have a choice when it comes to pay level to be misguided, because the forces of supply and

demand yield, in the long run, a single going/market wage that all employers must pay to avoid too high costs

in the product market on the one hand and the inability to attract and retain a sufficient quantity and quality of

workers in the labor market on the other. The only way that an employer could pay higher wages than other

employers would be if better quality workers were hired. In that case, the ratio of worker quality to cost would

be unchanged, meaning both that the apparent difference in pay levels was not real, disappearing upon ap-

propriate adjustment for worker quality and that employers would not necessarily realize any advantage from

using a high wage, high worker quality strategy. However, evidence of persistent and arguably non-illusory

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differences in compensation levels (see Gerhart and Rynes, 2003 for a review) between companies operating

in the same market has resulted in greater attention to why such differences exist and more general acknowl-

edgment, including in economics (Boyer and Smith, 2001), recognition that employers have some discretion

in their choice of pay level. In response, efficiency wage theory provides an economics-based rationale for

why some firms may benefit from higher (lower) wages.

5 This idea is similar to Karl Marx's concept of the ‘reserve army’ of unemployed being used by employers to

keep their workforces in line.

6 This section draws freely on Gerhart (2007).

7 This section draws freely on Gerhart (2008).

8 The d statistic is defined as the difference between the dependent variable mean for Group A versus Group

B, divided by the pooled standard deviation of Groups A and B. Thus, it gives the difference between Group

A and B in terms of standard deviation units.

9 This section draws freely on Gerhart and Rynes (2003).

BarryGerhart

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