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Chapter 12
Incentive Pay
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Introduction
• The chapter analyses how and why different methods of compensation arise
in the labour market and how they affect worker productivity and firm
profitablility. For example:
- Piece rates and time rates.
- Tournaments (to rank workers in a firm according to their productivity).
“To the winner go the spoils”
• Policy application: The compensation of executives
- Delayed compensation: Upward sloping age-earnings profiles
discourage workers from shirking.
- Efficiency wages.
• Only the material in the section on efficiency wages (Section 12.5) is
compulsary.
• Other sections should be of interest if you intend to join the workforce! Read
them at your leisure.
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Tournaments
• Some firms award promotions on the basis of the relative
ranking of the workers.
• A tournament, or contest, might be used when it is cheaper to
observe the relative ranking of a worker than the absolute level
of the worker’s productivity.
• Workers allocate more effort to the firm when the prize spread
between winners and losers in the tournament is very large.
• Disadvantages of tournaments with a large prize spread are the
inherent incentives for corruption (e.g. in sport) and ‘too much’
competition between participants (students/workers/managers)
(e.g. students stealing or hiding library books required for an
exam; in general, sabotaging work of fellow workers).
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Figure 12.3: The Allocation of Effort
in a Tournament
Dollars
MCA
Y
X
MRHIGH
MRLOW
Effort
Flow
The marginal cost curve gives
the “pain” of allocating an
additional unit of effort to a
tournament. If the prize spread
between first and second place
is large, the marginal revenue
to an additional unit of effort is
very high (MRHIGH) and the
worker allocates a lot of effort
to the tournament.
Fhigh
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Policy Application: Compensation of
CEOs determined by Tournament
• What should be the compensation package for a person who
runs a firm, yet does not own it?
The principal-agent problem: The conflict of interest between a
firm’s owners (the principals) and the manager/CEO (the
agent).
• There seems to be a positive correlation between firm
performance and CEO compensation, but the correlation is
weak.
- It is unlikely, therefore, that CEOs have the “right” incentives to
take only those actions that benefit the owners of the firm.
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Work Incentives and Delayed
Compensation
• Upward-sloping age-earnings profiles might arise because
delaying the compensation of workers until later in the life
cycle encourages them to allocate more effort to the firm, i.e.
they prevent shirking.
• A delayed-compensation contract also implies that at some
point in the future the contract must be terminated (because in
later years the firm pays the worker a wage greater than his/her
value of marginal product), thus explaining the existence of
mandatory retirement in many labour markets.
- Even if no mandatory retirement age, the structure of pension
plans might encourage workers to retire at a particular age.
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Figure 12.4: The Worker is Indifferent Between a Constant
Wage and an Upward-Sloping Age-Earnings Profile
Earnings
C
B
VMP
D
A
0
t*
N
Years on
the Job
If the firm could monitor a worker
easily, she would get paid her constant
value of marginal product (VMP) over
the life cycle. If it is difficult to
monitor output, workers will shirk.
An upward-sloping age-earnings
profile (such as AC) discourages
workers from shirking. Workers get
paid less than their value of marginal
product during the first few years on
the job, and this “loan” is repaid in
later years.
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12.5 Efficiency Wages
• Some firms might want to pay wages above the market-clearing competitive
wage in order to motivate the work force to be more productive.
• Some possible reasons for efficiency wages:
- In the context of poor countries, higher wages lead to better nutrition
resulting in higher productivity.
- Pay workers higher wages so that they have something to loose if they
do not perform and get fired. (‘shirking models’)
- Pay higher wages to attract higher ability workers, i.e. raise the average
quality of job applicants. Such workers are likely to have higher
reservation wages.
- Higher wages increase loyalty etc. Workers perform better if they
perceive their wages as fair. (‘fairness models’, ‘gift exchange models’)
- Higher wages can reduce quit rates (i.e. turnover), thereby reducing
recruitment and training costs. (‘labour turnover models’)
- Pay higher wages to ‘bribe’ workers not to join a union.
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Efficiency Wages ctd.
• Efficiency wage: The wage where the marginal cost of increasing the wage
(above the competitive wage level) exactly equals the marginal gain in the
productivity of the firm’s workers.
• Rule that determines the profit-maximising efficiency wage we:
- The efficiency wage is set such that the elasticity of output with respect
to the wage is equal to 1. This rule can be derived graphically (Figure
12.5) and algebraically. Students should understand both derivations.
- Slope of straight line = q/w. Equal to average product of a $ paid to
workers. Firm wants to achieve the highest q/w ratio possible.
- Slope of total product curve (i.e. marginal product) = ∆q/∆w.
- Highest q/w ratio possible where the two curves are tangent, i.e. have
same slope:
∆q/∆w = q/w
The wage that fulfills this condition is we! Re-write as:
(∆q/∆w) ∗ w/q = %∆q / %∆w = 1
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Figure 12.5: The Determination of
the Efficiency Wage
Output
Z
X
qe
Total Product
Curve
q¯
0
Y
Wage
w¯
we
The total product curve indicates
how the firm’s output depends on
the wage the firm pays its
workers. The curve embodies the
wage-effort relationship. It is
drawn for a given level of
employment. The efficiency wage
is given by point X, where the
marginal product of the wage (the
slope of the total product curve)
equals the average product of the
wage (the slope of the line from
the origin). The efficiency wage
maximises the firm’s profits.
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Efficiency Wages ctd.
• A profit-maximising firm will set we regardless of the value of the
competitive wage determined outside the firm!
• Because we is greater than the competitive wage, it creates a pool of workers
who are involuntarily unemployed.
• Different firms have different effort and production functions. Therefore,
they may have different efficiency wages.
• Evidence on efficiency wages:
- Classic example: Henry Ford, 1914.
- Quite a lot of fairly recent supporting evidence (p. 476/7). Permanent
wage differentials exist across firms etc.
Footnote 38: Krueger’s (1991) fast food industry study. Also see Footnote 39.
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Interindustry Wage Differentials
• Efficiency wage theory is one possible explanation for the
observed interindustry wage differentials that exist among
comparable workers.
- See Table 12.2. Interindustry (II) wage differentials are
observed for many countries, rich and poor, and they tend to
be very persistent over time!
- The competitive model would suggest that the II wage
differentials reflect differences in job characteristics and
unobserved worker traits.
- Efficiency wage theory would suggest that the II wage
differentials are NOT due to job & worker characteristics.
They arise because in some industries firms find it profitable
to pay higher wages, firms in other industries do not.
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Interindustry Wage Differentials ctd.
• Does the competitive model or the efficiency wage model
apply? Mixed and confusing empirical evidence (p. 479)!
- II wage differentials DO persist after controlling for job &
worker characteristics.
- But: Workers also DO sort themselves across industries.
- In short, BOTH types of explanations seem to apply, but how
much of the II wage differentials does each explain?
• Some NZ evidence on ‘raw’ II wage differentials (i.e. looking
at average industry wages without accounting for job & worker
characteristics).
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Efficiency Wages and
Dual Labour Markets
• The efficiency wage hypothesis generates an economy with
dual or segmented labour markets:
- Primary sector (worker’s output hard to observe and monitoring is
costly, e.g. ‘knowledge workers’) pays high efficiency wages.
“High wage industries”, “Good jobs” (also includes good working
conditions, employment stability, chances for promotion).
- Secondary sector (workers perform repetitive and monotonous taks,
output can easily be measured) pays low competitive wages.
“Low wage industries”, “Bad jobs” (dead-end jobs).
• With competitive labour markets, the wage differences between
primary and secondary sectors would disappear over time
(workers would move from low to high wage sector).
• With efficiency wages, the wage differences persist.
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The Bonding Critique
• The bonding critique is a criticism of the key assumption of the
efficiency wage model that there are permanent wage
differentials across firms.
• The bonding critique suggests that such wage differentials
self-destruct in the long-run because workers who want jobs in
the primary sector will be ‘willing to pay’ employers for the
right to be employed in that sector, e.g. by posting a bond at the
time of getting hired.
• More realistically, workers might at first accept wages below
their value of marginal product (a delayed compensation
scheme). This would tilt upwards the age-earnings profile in
high wage industries.
- Still an open question to what extent the bonding critique applies.
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End of Chapter 12
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