Topic Optimal Compensation Systems. Professor H.J. Schuetze Economics 370

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1 Topic Optimal Compensation Systems Professor H.J. Schuetze Economics 370 Optimal Compensation As we have previously discussed, it is often difficult to reconcile observed wage differences across individuals with the neoclassical model The neoclassical model suggests that workers are paid according to their value in output In reality we find compensation systems that appear contrary to this and that often appear inefficient e.g. - pay raises are often based on seniority instead of productivity - it often looks as though CEO s receive a prize rather than being paid their MRP N Professor Schuetze - Econ 370 2

2 Principal -- Agent Theory Can these be explained by institutional constraints that may or may not be efficient? (exogenous) Or is it possible that such compensation systems are, in fact, efficient? (endogenous) Principal Agent Theory: Deals with the optimal design of efficient contracts between the principal (employer) and the agent (worker) when there is imperfect information Contracts are particularly helpful when monitoring costs are high or when there is asymmetric information Efficient to design contracts with incentives that ensure the appropriate action is taken Professor Schuetze - Econ Principal -- Agent Theory With such contracts, whether explicit (like a collective agreement) or implicit (unwritten) worker s wages need not equal MRP N in every period We have already looked at one case in which it might be efficient for firms to pay wages that differ from the MRP N efficiency wages It was argued that the incentives created by efficiency wages increase the productivity of workers i.e. that wages affect productivity at the same time that productivity affects wages The idea that pay influences productivity is not unique to the efficiency wage model Professor Schuetze - Econ 370 4

3 Economics of Superstars How could it be efficient to pay superstars such high wages even if the superstar is only marginally better? It might be efficient if we consider the fact the MRP may reflect: 1. The size of the market 2. The contribution of the employee to other workers productivity Professor Schuetze - Econ Economics of Superstars Size of Market: If the size of the market does not detract from the ability to consume, small differences in skill may be highly rewarded e.g. Concert Size of the audience does not limit the ability of others to listen Can pay superstar salary to the best band Additional price to see the best band is small because it is shared among a large # of consumers Small skill differences get magnified by the size of the market Professor Schuetze - Econ 370 6

4 Economics of Superstars Productivity Spillover : Small differences in skill might also get magnified if a worker s skills enhance the productivity of other workers e.g. A talented hockey player might make team mates more productive as well An executive might have a positive effect on all members of a company The MRP of labour may be high even if the positive effect is small for each person Professor Schuetze - Econ Salaries as Tournament Prizes Even without productivity spillover it might be efficient to pay a slightly more productive worker a significantly higher wage This would be the case if the firm can not determine the precise contribution of each worker The firm, must be able to rank workers according to their relative contribution e.g. Group of executives Firm doesn t know the exact contribution of each but knows the productivity of the group Could pay each individual the average productivity of the group Professor Schuetze - Econ 370 8

5 Salaries as Tournament Prizes Problems: Leads to adverse selection Individuals with below average productivity want in the group No incentive for those in the group to perform well Might pay a prize in the form of a high salary to the top executive Able to do so because the firm can rank workers Creates an incentive to perform and win the prize Problems: May discourage cooperation (encourage disruption) Risk averse individuals might not join the group Professor Schuetze - Econ Efficient Pay Equity Given the previous discussion, it is clear that the equality (or inequality) of pay plays an important role It might be efficient to establish some inequality to provide an incentive for workers to perform Too much inequality can discourage cooperation or may result in sabotage The optimal degree of equality depends on: i. The degree of autonomy among workers The more workers affect each other s productivity the more equality will be optimal Want to encourage team behaviour Professor Schuetze - Econ

6 Efficient Pay Equity ii. The level of workers within the firm The higher the level the greater the potential for sabotaging Could make pay commensurate with group output to encourage cooperation Firms could keep competitive workers away from one another to prevent sabotage e.g. by promoting to separate departments Professor Schuetze - Econ Efficient Pay Equity iii. The optimal degree of competition or cooperation within a firm (depends on employees etc.) Some firms will get higher productivity by creating a competitive environment Some firms will do better with a more cooperative environment Note: Can t rely on workers to sort themselves between such environments Competitive employees have an incentive to enter cooperative environments and dominate This might explain why firms sometimes use personality traits in hiring decisions Professor Schuetze - Econ

7 Executive Compensation What can explain the very large and growing compensation packages of executives? Is compensation tied to performance? It might be efficient if high executive salaries act as a prize to motivate executives (as discussed) Also, if the salary attracts a superstar who increases the productivity of a large firm it might make sense Thus, high salaries might be needed to bid for executives with talents that are valuable to a firm However, executive salaries might also be high because of the complex institutional arrangements whereby such salaries are set Professor Schuetze - Econ Executive Compensation Executive salary typically consists of a base salary along with stock options Stock options may provide an incentive for the executive to perform However, base salary is set by the Board of Directors who may have an incentive to set high executive salaries Board members are appointed by the CEO and are executives themselves Shareholders may act as a check but evaluating executive salaries is complex Despite this there is evidence of a positive relationship between executive salaries and firm performance Professor Schuetze - Econ

8 Deferred Wages Refers to the fact that for many wages rise with seniority rather than with productivity Wages are deferred in this case because workers are paid a wage below productivity early on while more senior worker s wages are above productivity The extent to which compensation is deferred is magnified by the fact that pensions are typically tied to salary in the latter years Therefore, firms pay higher wages along with increments to pensions as deferred compensation Professor Schuetze - Econ Deferred Wages W MRP N A market in which there is a deferred wage contract can be depicted as follows: Worker is paid below MRP prior wage to S MRP B N Worker is paid above MRP after S B The firm has an incentive to release employees with seniority S B seniority greater than S B Must be that there is a long-term contract or arrangement to keep workers beyond SB The long-term commitment might be ensured by: The reputation of the firm Unions Professor Schuetze - Econ

9 Efficiency of Deferred Wage Contracts Are such contracts efficient? From the firm s perspective deferred wage contracts may be rational for a number of reasons: 1. Might help to ensure that workers perform satisfactorily Workers don t want to be fired before they receive their deferred wages 2. Could reduce the need for constant monitoring of employees Monitoring can be done periodically where receipt of deferred wage is conditional on prior performance This particularly appealing to firms with high monitoring costs Professor Schuetze - Econ Efficiency of Deferred Wage Contracts 3. May reduce worker turnover Workers wish to collect deferred wage This reduces costs to firms with large quasi-fixed costs (hiring and training) Example: Firm Specific Training W MRP N S T S B wage MRP N seniority Training (0-S T ): during training the worker s MRP is low The firm incurs costs equal (w-mrp) Recouping Costs (S T -S B ): the firm recoups costs in this range In order to ensure this firms might pay deferred wages Deferred wages (S B +) Professor Schuetze - Econ

10 Efficiency of Deferred Wage Contracts Note: in the case of general training the firm has no incentive to pay the training costs Once trained the employee can take the skills developed to another firm to receive a wage equal to MRP (i.e. no recouping period is possible) 4. Might provide workers with a financial interest in the firm If the firm goes bankrupt deferred wages aren t paid Creates an incentive to be more cost conscious 5. Public sector employers might prefer deferred wages Costs are passed on to future generations Difficult to monitor public sector workers Professor Schuetze - Econ Efficiency of Deferred Wage Contracts From the employee s perspective deferred wage contracts might also be rational 1. Long-term contract reduces the risk of unemployment 2. Deferred wage contract reduces monitoring 3. Forces workers to save for their retirement Not necessarily more efficient than private markets 4. Corresponds to a sense of equity and fairness Wages increase with seniority irregardless of productivity Professor Schuetze - Econ

11 Mandatory Retirement W MRP N Deferred wages also create an incentive for more senior workers to continue working indefinitely Mandatory retirement clauses require workers to retire (terminate current contract) at a certain age Without mandatory retirement firms would not likely enter into deferred wage contracts MR=mandatory retirement age wage With mandatory retirement firms MRP N can choose MR such that: P.V. Wages = P.V. Productivity Suggest that mandatory retirement might be endogenously determined MR Age Professor Schuetze - Econ Other Rationales for MR 1. Might open up employment opportunities for younger workers (work sharing) Have to be careful to avoid the lump of labour fallacy 2. Creates certainty about one s retirement age Helps employees and employers plan for retirement 3. Reduces the possibility of dismissal of older workers for incompetence Allows firms to reduce monitoring of older workers * These are likely side effects of mandatory retirement rather than reasons for implementing such a strategy Professor Schuetze - Econ

12 Arguments Against MR 1. Regarded as a form of age discrimination This is enhanced by the fact that employment standards and human rights legislation typically do not cover those over age May place increased pressure on pension obligations Problems associated with aging of the work force and pension crisis may be averted if workers can work beyond the typical retirement age Professor Schuetze - Econ