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Pay Systems Notes

PPE Notes > Labour Economics: Pay Systems Revision Notes

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Labour Economics: Wages and Salary Structures, incentives and payment systems revision ContentsOverview Importance of Compensation Agency Model Time Rates Piece Rates Individual Merit Pay Group Merit Pay Profit Sharing/Group wide incentives Deferred Compensation Other Paradigms o Loyalty o Productivity o Social custom approach (neglected by economics) o P/A Theory and Promotion o Pensions o Alternative Motivation Methods

- No tendency for merit pay to decline. More dominant in private sector than public sector (increased in private sector 2004-2011). Decline in payment by results. Share incentive schemes.
- Time rates and piece rates historically dominant
- Depends on industry itself and nature of work within industry - verifiability of effort. IMPORTANCE OF COMPENSATION MILGROM & ROBERTS (1992) importance of compensation (PADS): o Prompt unwanted candidates to leave o Attract/retain employees o Determine employees' allocation of time/effort o Signal organisation values and what behaviour it wants to encourage AGENCY MODEL
- Agency model with hidden action: analyses remuneration rule that riskneutral principal offers when results are verifiable.
- Moral hazard problem. Divergent interests and asymmetric information.
- Agent acts on behalf of principal to advance their goals. Employer: principal; employee: agent.
- Y = F(e,v - state of world variables). Both manager and employee's utility F(w,e), but opposite partial derivatives o Manager/principal: du/dw < 0, du/de > 0 o Employee/agent: du/dw > 0, du/de < 0
- Not problematic if a) effort is verifiable and b) manager holds authority so can impose will on workers. Then can set up punishment reward system which may need calibration but will extract relevant amount of effort. But, rare - trade unions initially hampered authority. Still remains an issue some managers in fact scared of exercising authority - economists don't appear to understand.

-In fact, effort usually often nebulous/impossible to observe. Do the solutions solve the observation problem or just formalise it? Do they help or should we just stop there?
Use remuneration systems to realign. Sequential model:
? 1. Principle offers a contract
? 2. Agent accepts/turns down contract
? 3. If rejects, go separate ways.
? 4. If accepts, supplies an effort
? 5. Principal and agent observe the result
? 6. Principal remunerates agent Game theoretic: optimal incentive found through backwards induction
? Employee exerts effort e at personal cost C(e) to serve employer. Employer uses output as indicator of e. z = e + x where z = sales, e = effort, x = random events.
? Linear compensation: w = a +bx. Model finds optimal level of incentives b* - compromise between insurance and incentive. Balances direct net marginal benefit against marginal transaction cost.
$/intensity marginal net benefit both lines: marginal transaction


Incentive intensity


M & R (1992): Principles governing optimal design of contracts (MERII):Monitoring intensity principle
? More resources should be spent monitoring when it is desirable to give strong incentives.Equal compensation principle
? If employee's allocation of time between two tasks cannot be monitored, marginal returns between two tasks must be equal.Ratchet effect:
? Punishes yesterday's good performance by setting higher standards today.Informativeness principle
? Cost of providing incentives increases with variance of estimator of employee's effortIncentive-intensity:
? Incentives should be increasing function of marginal returns to task, agent's responsiveness and risk tolerance

- Provide least risk to risk-averse workers and least administrative/monitoring complexity.
- Moral hazard problem severe. Stems from information asymmetries. Manifested in 2 ways: o 1. Principal cannot measure output. o 2. Can't measure relationship between input and output PIECE RATES
- Again, not problematic if manager can observe output and know relationship between effort and output. That is justification for piece rate systems - base rate of pay, standard target for number of pieces eg in week, pre-declared extra amount of pay for each item produced over standard target. Assumes pay is your solution. Tells us certain forms of processes where it's a possibility. Eg. Clothing/car factory. Difficult thing to do in retail bank.
- Explicit incentive pay: specified amount per unit produced. o Eg.picking strawberries o Eg. Salesman depending on commissions
- PA theory: if effort non-verifiable but employer can observe output of worker and knows relationship between effort and results, can remunerate calibrated on amount of output to get optimal effort. Eg. Piece rates Advantages
- Increase productivity: o LAZEAR (2000): large autoglass installer in US. Average productivity rose 22%. o SHEARER (2004): investigation of tree-planting, productivity increase 15-35%
o Though, selection bias: may attract people who are more productiveSimple to understand: o Enables motivation o Facilitates implementation process o Avoids need for complicated/subjective performance reviews. Reduced tensions.Can encourage employees to improve skills


1. Employees may neglect other important concerns - eg. Quality of output, helping others, maintenance of tools (unless stay in job long enough). Need strong management to prevent quality deteriorating rapidly. Ie goes against Equal compensation principle. Eg. teachers - cash incentives for test results would neglect wider aspects of education.

2. Implementation challenging: Too low = lower net profit for firms. Too high =
consistently low levels of pay, low morale, quits etc. Incentive-intensity principle: indicates ought to be set higher with: o Higher additional profits from extra effort o Less risk averse employees o Greater extent to which measured output reflects individual effort o Greater opportunities to increase incentives o But, analysis of intertemporal incentives and ratchet effect: workers have incentive in standards being set low. Behave disingenuously in measurement period prior to piece rate setting, deliberating limiting their pace.

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