1

Alternative Pay Schemes and Labor Efficiency

2

Fringe benefitsTotal compensation of employees = wages + fringe benefits

Fringe benefits = public programs(like social security) +private programs(like medical and dental, pensions, paidvacation and sick leave).

About 72% of compensation is in wages and 28% is in fringes.

In 1955 fringes made up about 15% of compensation.

3

Optimal fringe benefit theoryTo understand why something like fringe benefits has changed in our economy, economists come up with theories. The theory we will look at is a modification of the labor leisure model we saw earlier.

Our theory will have indifference curves and a budget constraint.

4

Indifference curvesRemember that an indifference curve shows combinations of goods that yield the same level of utility for the individual. The goods we are talking about here are wagesand fringe benefits. The indifference curves for an individual summarize theirsubjective view about the trade-off between wages and fringe benefits.Some have wondered why fringe benefits would be ofinterest to people. It seems that a dollar in fringe benefits isless beneficial than a cash equivalent. As an analogy consider the following: Which would you rather I give you, a snicker bar or the money amount of the snicker? With themoney you could buy the snicker bar or something else, if that made you happier.

5

Indifference curvesThere are two reasons fringe benefits (FBI) may be traded-off with wages:1) tax advantages2) may be the only way we ‘buy’ some things

6

tax advantageExampleSay a worker has no FBI, has 30,000 in income, the first 20,000 of which is taxed at 15% and the rest at 28% and the worker puts 2,000 into retirement.The tax for the worker is 20,000(.15)+10,000(.28) = 5,800.After taxes and retirement the worker has 22,200 left to spend.Now say a worker has FBI in that 2000 can be put intoretirement before it is taxed as income.The tax for the worker is 20,000(.15) + 8000(.28) = 5240 andafter the tax and retirement the worker has 22,760 left to spend.The fringe leads to 560 tax decrease. Maybe we would trade FBI for wages.

7

‘buy’ what is good for usFor many of us we get paid and that money is spent

beforeour next paycheck - we enjoy the good life.

We are willing to give up wages because1) we will still enjoy the good – save 10% of all you

earn and you probably won’t notice a difference. 2) we will get some stuff like health care and

pension plans that we might not have purchased on our own. Without the fringe benefit we might be like a kid in a candy store and not get exactly what we really should.

8

indifference curve graph

fringe benefits

wages

So the indifference curves are much like we have seen inthe past. They are downward sloping and convex to the origin.

9

The budget lineThe budget line represents what the worker can trade-offin the market. But here the firm plays a role.The firm looks at total compensation of employees to figure what maximum profits might be. If the firm takesa dollar of wages away and gives a dollar of FBI, its compensation wouldn’t change. So initially our understanding of the budget is that for every dollar givenup by firms, a dollar in FBI is returned.

W

FBI

11

10

The budget lineThe budget line can actually rotate counter clockwise if weconsider 1) tax advantages to the employer2) economies of scale3) efficiency of labor with fringes.

W

FBI

11

On the budget line farther out, the firm cangive back more than a dollar of FBI when a dollar of wages is takenaway.

11

tax advantage for employerSay a worker gets paid 30,000. The firm has to contribute7.65% of income to social security and medicare. This means the firm has to pay 2295 in social security tax. The real cost to the firm is32295 to have this worker work in the firm.

When FBI are given the dollar value is not subject to social security taxation. So if the firm takes a dollar of wages away it can offer the dollar plus the tax saving of 7.65 centsback in FBI.

12

Economies of scaleIf each worker bought their own insurance it would costx dollars. With the firm buying a group plan, the group rate means the worker could get more than x dollars worth of insurance for the same x dollars if those dollars are now taken as FBI.

I am a bit skeptical of this argument. If this really is the case,why don’t we do our car insurance the same way?

13

efficiencyAll dollars in expense to the firm are not the same. Let’s us an example to try to see what this means.case 1Workers only stay at a company for a year because thereare no FBI.year 1 $1 in training cost yields x output.year 2 $1 in training cost yields x output.case 2Workers stay longer than a year because of FBIyear 1 $1 of training cost yields x output.year 2 $1 of FBI yields x+y output.So workers that stay longer at a firm may become more productive and thus the firm can offer more than a dollar in FBI for every dollar of wages taken away.

14

optimal amount of FBIW

FBI

The optimal amount of FBIoccurs where the workercan get on the highestindifference curve but stillbe on the budget line. Thisoccurs on curve 2 and theworker gets the amount ofFBI represented by FB1.

FB1

123

15

optimal amount of FBIW

FBIFB1 FB2

Over time as the budget line has shifted out due tothe ideas mentioned above,we see the the optimal amount of FBI has increased(so have wages).

123