RKO Warner Video Videotape rental firm in NYC Problems In 1988 24 video stores in NYC (one of the largest stores at the time) Big inventory of tapes High quality service Attractive décor Problems Turnover was very high Quality and consistency of store managers varied across the chain

RKO Warner Video Decision rights were bundled into jobs Store manager tasks: Make sure videos are alphabetized Keep the store clean Make sure the store opens and closes on time Reward system didn’t motivate effort 1988: Bonus plan introduced Pre-bonus managers made $21-28,000 Post-bonus made more in bonuses than with regular pay. Average salary rose by an average of 15%

Contracting Objectives It is in the interest of both employee and firm to maximized the value created in the relationship Reservation Utility Individuals will not participate in a labor relationship until they obtain at least the utility they can get elsewhere. This is called the “reservation utility.” In a competitive market, paying more than the competitive amount may put the firm at a disadvantage relative to other firms

Basic 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

Basic Competitive Model Wage in $ Market Wage Rate Marginal Revenue Product of labor E E* Number of Employees

Human Capital Basic Terminology Types of Human Capital Human Capital Investment in Human Capital “rate of return” on Human Capital Types of Human Capital General Specific

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 Compensating differentials provide a reward for firms making jobs safer or more pleasant. For example, the above statistics imply that a firm with 1,000 employees could reduce wages by $20,000-$300,000 per year by preventing one accidental death every 10 years.

Compensating Differentials Compensating differentials get people to do unpleasant jobs Compensating differentials provide reward for firms that make jobs more pleasant Compensating differentials allow workers to self-select by willingness to take risks

Costly Information About Market Wages 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

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

Internal Labor Markets Some firms hire entry level positions externally, but train and promote from within the firm 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

Tradeoffs in Long-Term Employee Agreements Advantages 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

Pay in Internal Labor Markets Often employees are asked to take less money early in their career than they could get elsewhere, but they are paid more than they could get elsewhere later Compensation Salary Marginal Revenue Product of Labor Tenure with the firm

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 Much time may be spent lobbying managers for promotions

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

Indifference Curves Between Salaries and Fringe Benefits Monetary Compensation Utility = U2 Utility = U1 Fringe Benefits

Iso-Cost Lines Between Salaries and Fringe Benefits $50 K Iso-cost line at $50,000 ($50K) of total payment Monetary Compensation Slope = -1 $50K Fringe Benefits

Iso-Cost Lines Between Salaries and Fringe Benefits $50 K Monetary Compensation $30K $20K $50K Fringe Benefits

Fringe Benefits Payroll taxes Applications 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.