Labour Economics assignment 1
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Chapter13.pptxChapter Thirteen Optimal Compensation Systems, Deferred Compensation, and Mandatory Retirement
© 2012 McGraw-Hill Ryerson Ltd.
Prepared by Dr. Amy Peng
Ryerson University
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Learning Objectives
Understand why certain compensation arrangements that at first glance seem inefficient may be optimal mechanisms to align the incentives of employers and employees or stockholders and management.
Explain why these optimal compensation arrangements may change over time or differ across different countries or workplaces.
Understand the “new economics of personnel” and to see if it offers insights into the workplace and human resource practices of organizations.
Engage in the debate as to whether CEOs are “worth” their often astronomical pay or essentially “milking” their organization and its stockholders.
Understand why mandatory retirement may exist and the implications of legislatively banning mandatory retirement.
Chapter 13
© 2012 McGraw-Hill Ryerson Ltd.
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Agency Theory and Efficiency Wage Theory
Agency Theory
The framework applied is the principal agent problem:
Deals with the problem of designing an efficient contract between the principal and the agent when there are incentives to cheat
Problems rise with asymmetric information
Eliciting a “truth-telling” contract
Examples of such contracts are: collective agreements or implicit contracts
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Agency Theory and Efficiency Wage Theory
Efficiency Wage Theory
Wages affect productivity
Wages are being paid according to value of marginal product of labour
Emphasizes that subsistence wage is necessary for basic levels of nutrition, reproduction, and higher productivity
The result of higher wages is efficiency gains
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Economics of Superstars
Small differences in the skill input of certain individuals may get magnified incredibly in the value of marginal product of the service consumed by the public or co-workers in certain circumstances (ex. concert, TV show)
A small positive effect on each person can accumulate into a large total effect when the number of affected persons in the organization is large (ex. executives, talented individuals)
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Salaries as Tournament Prizes
Promotion on the basis of being the best (of several executives with seemingly equal ability), results in a huge increase in the salary
Treated as prize of winning a contest
Based on capability
Increases the incentive to perform
Important to senior persons who have few promotional opportunities left
Discourages cooperative behaviour
Fosters corruption
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Efficient Pay Equality, Teams, and Employee Cooperation
Inequality of pay is necessary to provide an incentive to perform well
Too much inequality is not efficient since it:
Discourages cooperative behaviour and teamwork
Encourages sabotage
Solution:
Different pay incentive schemes for different levels within an organization
Higher-level managers’ bonuses on the basis of group output
Separate business units
External promotion
Human resources policies to encourage cooperative behaviour
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1/N Problem
Paying people on the basis of the average performance of team members
“Free rider” problem
Large team – little incentive
Small team – Peer pressure
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Efficient Pay Equality, Teams, and Employee Cooperation
Up-or-Out Rules
Under such rules employees are evaluated usually at a specified point in their career and either promoted or terminated (e.g. tenure at universities)
Appears to be inefficient practice that causes loss of workers with lower productivity
Solution
Using junior non-promoted slots to evaluate new candidate
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Efficient Pay Equality, Teams, and Employee Cooperation
Raiding, Offer-Matching, and the Winner’s Curse Asymmetric information issues give rise to organizations engage in raiding other organizations for top talent
The organization being raided
would offer-matching of the outside offer if the person were truly worth that amount
would not match the offer if the person were not worth that amount.
The raiding organization suffer from the “Winner’s Curse”
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Efficient Pay Equality, Teams, and Employee Cooperation
Piece Rates: workers are paid on the basis of the output they produce.
Benefits:
Workers producing more output
Systems attracting good workers
Save on the cost of monitoring
Drawbacks:
Harder to monitor output of an individual
Costly
Harder to sustain the system if the individual does not have a large degree of control over the output
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Executive Compensation
Executive pay has increased relative to the average pay of workers
Executive compensation consists of a base salary and stock options
Compensation process involves the board of directors who have an incentive to award high executive salaries because they are themselves executives
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Deferred Wages
Wages above an individual’s productivity:
Senior employees
Wages rise with seniority independently of productivity
Wage increase and pension accrual for each additional year of work
Characteristics:
Exist only if there is a long-term commitment on the part of the firm to continue the contracted arrangements
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Wage Productivity Profiles
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Deferred Wages Contract Market:
Wages rise more rapidly than productivity reaching a breakeven point and than being above productivity at higher levels
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Wage Productivity Profiles
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Spot Market:
Wages are equal to productivity at each and every level of seniority
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Wage Productivity Profiles
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Deferred Wages with Company-Specific Training:
Wages are above individual’s productivity during the initial training period (up to St ), thereafter a deferred wage profile is received
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Wage Productivity Profiles
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General Training:
Wages are considerably below productivity in the initial general training period up to St
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Deferred Wages
Efficiency rationale:
Increases work honesty and effort
Reduces the need for constant everyday monitoring
Reduces unwanted turnover
Reduces fixed hiring and training costs
Discourages bad workers
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Deferred Wages
Do workers also prefer deferred wages?
Researchers observed that workers actually preferred the rising wage profiles
They regard them as forced saving
They get satisfaction for anticipating future consumption
Individuals seemed to give up current wages in return for future wages
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Mandatory Retirement
Rationales:
To enable deferred wages
As a result the expected present value of the wage stream is equal to the expected present value of the productivity stream to the firm
Gives finality to the existing contractual arrangement
Efficient compensation rule
Opens up promotion and employment opportunities for younger workers
Creates a greater degree of certainty about the date of retirement
For employers: facilitate planning for new stuffing requirements, pension obligations, and medical expenditures
For workers: encourages pre-retirement planning
Reduces the cost of monitoring of older workers
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Mandatory Retirement
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The mandatory retirement age (MR) is such that the present value of the underpayment
(i.e., the area below the VMP line and the wage
line) is equal to the present value of the overpayment (i.e., the area below the wage
line and above the VPM line) in the latter period.
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Mandatory Retirement
Arguments Against Mandatory Retirement:
Human rights issues (a form of age discrimination)
If one is able, wants to continue, and capable of working productively, they will still not be able to do so (efficiency-loss)
Improving the viability of public and private pensions
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Mandatory Retirement
Impact of Banning Mandatory Retirement
Some theoretical predictions:
Changing the age earning profile to coincide with productivity (higher wages for younger workers and lower wages for older workers)
Possible changes of deferred wages systems
Possible Increase in the monitoring and evaluation of workers
Reduction in the employment opportunities for younger workers
Reduction in training
More difficult forecasting and planning
Possible redesigning of jobs to accommodate older workers
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Summary
Agency and Efficient Wage Theories
Economics of Superstars
Salaries as Tournament Prizes
Inequality in Pay
Up-or-Out Rule: Drawbacks and Resolution
Piece Rates: Positives and Negatives
Executive Compensation
Deferred Wages: Characteristics and Rationale
Mandatory Retirement: Rationales, Impact, and Causes
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