ECON 308: Employment Decisions

Chapter 14Attracting and Retaining Qualified Employees

Chapter 16 Individual Performance Evaluation

Week 14: Nov. 30 , 2012

1

Attracting & Retaining Employees

• Principles:– Maximum Value: Marginal Revenue Product

(willing to pay)– People won’t come to your firm until you make

them at least as well of as the could be elsewhere (Opportunity Cost: Have to pay)

– Paying more than is needed to attract employees puts a firm at a competitive disadvantage

– It is in the interest of both employee and firm to maximized the value created in the relationship

2

Chapter 14 Organization

• No-frills Competitive Labor Market• Some complications

– Human Capital– Compensating Differentials– Costly Information– Internal Labor Markets– The Salary-Fringe Benefit Mix

3

No-Frills Competitive Model

• Labor market is competitive – no discretion over wages

• Market Wages are costless to observe• Workers are identical• Jobs are identical• All labor is rented on the spot market• All compensation is monetary

4

Basic Competitive Model

Number of Employees

E

Wag

e in

$

Marginal Revenue Product of labor

Market Wage Rate

E*5

Human Capital

• Terminology– Human Capital: Skills– Investment in Human Capital: Education, OJT– “rate of return” on Human Capital: MB > MC

• Types of Human Capital– General (Excel, Word, text messaging)– Firm Specific: (proprietary software)

6

Compensating Differentials

• Consider 3 Welding jobs– Job X pays $8/hour in clean, air-conditioned

safe working conditions, – Job Y pays $8/hour in a dirty, outdoor

construction site,– Job Z pays $8/hour in ship construction

yard.• Is this an equilibrium wage?

7

Compensating Differentials

• Must pay more when a job has undesirable characteristics– $20-300 more must by paid for every 1/10,000

increase in the probability of being killed on the job

– A firm with 1,000 employees could reduce wages by $20,000-$300,000 per year by preventing one accidental death every 10 years.

• Knowledge of necessary CD how to invest in alternatives: safety devices

8

Compensating Differentials

• Implications– Unpleasant jobs get done– Companies are rewarded for making

jobs more pleasant– Workers may choose the level of risk

they wish to face

9

Compensation Information: Costly to acquire

• Compensation may be hard to see– Workers differ in human capital so they may

differ in the compensation offered– Firms don’t share all of the details of

compensation with prospective employees• Symptoms…

– …of over-paying: too many qualified applicants– …of under-paying: few applicants, high

turnover

10

Problems with under-paying

• Low compensation is associated with high turnover so costs of re-training are high

• When turnover is high there may be incentive problems

11

Internal Labor Markets

• Hire at entry level, promote from within– Law Firms, Accounting Firms, Hospitals– In 1991 an employee between 45 & 54 had

typically been with the same employer for 10 years or longer

– Half of all men and ¼ of women stay with the same firm at least 20 years

• Most Internal Labor Markets rely on implicit contracts

12

Tradeoffs in Long-TermEmployee Agreements

• Benefits of internal labor markets– Accumulates more firm-specific human capital– Better motivation– There is incentive to avoid behavior that is

dysfunctional in the long run– Managers know more about employee attributes

• Costs of internal labor markets– Restricted competition for advanced jobs

13

Pay in Internal Labor Markets

Tenure with the firm

SalaryCompensation

Marginal RevenueProduct of Labor

14

Tradeoffs with Career Earnings• Advantages

– Efficiency wages reduce turnover and shirking– Since pay rises faster than MRPL employees have strong

incentives to make the firm look good– Promotions become a reward for good behavior

• Disadvantages– Promotions may be manipulated because of destructive

behavior toward other rivals– Promotions are a crude incentive tool since they are

infrequent– The Peter Principle: People rise to level of incompetence– Much time may be spent lobbying managers for promotions

15

The Salary-Fringe Benefit Mix

• Fringe Benefits account for about 25% of compensation for the average American

• Examples– Health Insurance– Non-Social Security pension programs– Subsidized Education– Discounted Meals

16

Indifference Curves Between Salaries and Fringe Benefits

Fringe Benefits

Mon

etar

y C

ompe

nsat

ion

Utility = U1

Utility = U2

17

Iso-Cost Lines Between Salaries and Fringe Benefits

Fringe Benefits

Mon

etar

y C

ompe

nsat

ion

Slope = -1

Iso-cost line at $50,000 ($50K) of total payment$50 K

$50K

18

Optimal combination: Salaries and Fringe Benefits

Fringe Benefits

Mon

etar

y C

ompe

nsat

ion

$50 K

$50K$20K

$30K

19

Fringe Benefits• Payroll taxes

– Make the iso-cost line flatter– The total tax-bill (including the part paid by the

employees) will matter in determining the optimal mix of fringe benefits

• Applications– Fringe benefits can be used to screen for particular

types of employees– Cafeteria-style plans are desirable when

administration costs are low and when adverse selection is not a problem.

20

Chapter 16: Individual Performance Evaluation

ECON 308

Week 14

Performance Evaluation

• Evaluations provide employees feedback on achievement and ways to improve

• Evaluations are used to determine rewards and sanctions

• Performance evaluation entail evaluating employees as well as subunit of the firm

16-22

Implicit Assumptions• Principal knows agent’s production function• Output is single quantitative measure of

performance• Output can be observed at zero cost• Employee cannot game the measure• Employee produces a single output• Mutually beneficial contract is feasible• Employee works independently

16-23

Setting Performance Benchmarks

• Time and motion studies– Engineers estimate the amount of time a task

requires– Determines most effective work method

• Past performance and ratchet effect– Employees have incentives to only meet the

goal and not exceed it

16-24

Measurement Costs• Accounting system may need to be

developed

• Information systems improved

• Value-maximizing firm improves measures as long as incremental benefits justify costs

16-25

Opportunism

• Gaming– Employees may engage in dysfunctional

activities to improve their evaluations

• Horizon problem– Short-run objective performance measure

may cause employees to focus on results that influence their evaluation only over their remaining time with the firm

16-26

Relative Performance Evaluation

• Evaluate worker output relative to their co-workers in the same job

• Within the firm– jobs not always identical– group has incentive to punish “rate busters”– incentive to hire less competent workers

• Across firms– data hard to obtain

16-27

Subjective Performance Evaluation

• Firms often use subjective evaluation along with objective measures

• Multiple tasks and unbalanced effort– Workers have incentives to concentrate on

activities that are easily measured– The subjective measure will allow the

supervisor to determine cooperation and other difficult to measure activities

16-28

Subjective Evaluation Methods• Standard rating scales

– Rank employees on various performance factors

• Goal-based systems– Set annual goals and then measure whether

the employee achieved them

• Frequency– Often more frequent reviews are too costly– May be beneficial with new hires

16-29

Problems with Subjective Evaluations

• Supervisor shirking

• Forced distribution– May result in good employees being

evaluated poorly

• Influence costs

• Reneging

16-30

Combining Performance Measures

• Few job performance measures are purely objective or subjective

• Both types can be inaccurate– increasing inaccuracy of either places greater

weight on other– inaccuracies increase employee risk

• Both can induce dysfunctional behaviors

16-31

Comparing Individual and Team Output

25

2.5

Conrad’s and Dina’s individual effort levels

Exp

ecte

d ou

tput

Conrad and Dina’s team output

Q

e

Sum of Conrad’s and Dina’s individual outputs

16-32

Government Regulation of Labor Markets

• Anti-discrimination regulations dictate clear performance evaluation systems

• May be inconsistent with value maximization

16-33