# Performance related pay 1. Background 1. Background 2. Effects 2. Effects 3. Empirical evidence 3. Empirical evidence 4. Problems with PRP 4. Problems.

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Performance related pay 1. Background 1. Background 2. Effects 2. Effects 3. Empirical evidence 3. Empirical evidence 4. Problems with PRP 4. Problems with PRP

1. Background Recall Recall –Output depends on worker effort –Workers have free will effort & specific skills effort & specific skills effort is a bad, higher wages are a good effort is a bad, higher wages are a good –Firms wish to maximise effort / skill use Divergence of interests – principal-agent problem Divergence of interests – principal-agent problem Informational asymmetries Informational asymmetries

1. Background Old Pay versus New Pay Old Pay versus New Pay –Old pay systems job evaluated grade-wage structure job evaluated grade-wage structure pay = f(time, seniority, job characteristics) pay = f(time, seniority, job characteristics) –New Pay systems Pay related to firms strategy Pay related to firms strategy Flexible & variable pay systems Flexible & variable pay systems

1. Background Types of PRP incentive scheme Types of PRP incentive scheme –(i) Piece rates: w = f(Q) –(ii) Commission on sales –(iii) Group-based PRP I.e. bonus systems (US = gainsharing) –(iv) Profit sharing

2. Effects of PRP Three (expected) effects, compared to what? Three (expected) effects, compared to what? –(i) Effort & output will rise –(ii) Average level of earnings will rise –(iii) Variance of effort & wages across workers in a firm will rise

3. Empirical evidence Lazear (2000) Lazear (2000) –Safelite Glass Corporation –Data 3,707 workers, 19 months = 38,764 person- months 3,707 workers, 19 months = 38,764 person- months Output = average no. of glass units installed per day in a month Output = average no. of glass units installed per day in a month –Methods Regression with & without fixed effects Regression with & without fixed effects

3. Empirical evidence Findings Findings –Output per worker rose by 44 percent A) average worker produces more – incentive scheme A) average worker produces more – incentive scheme B) hire more productive workers & reduction in quits amongst the most productive workers B) hire more productive workers & reduction in quits amongst the most productive workers –Workers received a 10 percent increase in pay –Variance in output increased –Effect on profits? –Effect on quality of output? Effects are large & in line with economic theory Effects are large & in line with economic theory

3. Empirical evidence Gregg, Jewell & Tonks (2005) Gregg, Jewell & Tonks (2005) –Executive pay & company performance in the puzzle –Panel data - UK Time: 1994-2002 Time: 1994-2002 Companies: 415 Companies: 415 Total observations 2,859 Total observations 2,859 –Methods ExecPay it =µ i + α t + β 1 (CompPerform) + β 2 (Controls) + e it ExecPay it =µ i + α t + β 1 (CompPerform) + β 2 (Controls) + e it

3. Empirical evidence Literature Literature –Low pay-performance sensitivities for UK firms (elasticity= 0.15) –Total compensation matters more Main et al (1996) – share option – elasticity Main et al (1996) – share option – elasticity –increased from 0.15 to 0.71 (total board remuneration) –Increased from 0.23 to 0.9 (highest paid director)

3. Empirical evidence Findings Findings –Total board pay rose by 33% over the period –Mean pay of highest paid director increased by 45% in real terms –Regression results Firm size has the biggest effect Firm size has the biggest effect Total share holder return has a much smaller effect Total share holder return has a much smaller effect

4. Problems implementing PRP a) Individual output – difficult to measure a) Individual output – difficult to measure b) Time & performance b) Time & performance c) Team production, effort & output c) Team production, effort & output d) Teams & Group output d) Teams & Group output e) Multi-task workers – performance e) Multi-task workers – performance Other pay mechanisms Other pay mechanisms

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