ECON 308: Employment Decisions Chapter 14 Attracting and retaining qualified employees Week 13: April 19,

Attracting & Retaining Employees Principles: – Maximum Value: Marginal Revenue Product (willing to pay) – People won’t come to your firm until you make them at least as well of as the could be elsewhere (Opportunity Cost: Have to pay) – Paying more than is needed to attract employees puts a firm at a competitive disadvantage – It is in the interest of both employee and firm to maximized the value created in the relationship 2

Chapter 14 Organization No-frills Competitive Labor Market Some complications – Human Capital – Compensating Differentials – Costly Information – Internal Labor Markets – The Salary-Fringe Benefit Mix 3

No-Frills 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 4

Basic Competitive Model Number of Employees E Wage in $ Marginal Revenue Product of labor Market Wage Rate E* 5

Human Capital Terminology – Human Capital: Skills – Investment in Human Capital: Education, OJT – “rate of return” on Human Capital: MB > MC Types of Human Capital – General (Excel, Word, text messaging) – Firm Specific: (proprietary software) 6

Compensating Differentials Consider 3 Welding jobs – Job X pays $8/hour in clean, air-conditioned safe working conditions, – Job Y pays $8/hour in a dirty, outdoor construction site, – Job Z pays $8/hour in ship construction yard. Is this an equilibrium wage? 7

Compensating Differentials Must pay more when a job has undesirable characteristics – $ more must by paid for every 1/10,000 increase in the probability of being killed on the job – A firm with 1,000 employees could reduce wages by $20,000-$300,000 per year by preventing one accidental death every 10 years. Knowledge of necessary CD  how to invest in alternatives: safety devices 8

Compensating Differentials Implications – Unpleasant jobs get done – Companies are rewarded for making jobs more pleasant – Workers may choose the level of risk they wish to face 9

Compensation Information: Costly to acquire 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 10

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 11

Internal Labor Markets Hire at entry level, promote from within – Law Firms, Accounting Firms, Hospitals – 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 12

Tradeoffs in Long-Term Employee Agreements Benefits 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 13

Pay in Internal Labor Markets Tenure with the firm Salary Compensation Marginal Revenue Product of Labor 14

Tradeoffs with Career Earnings Advantages – Efficiency wages reduce turnover and shirking – Since pay rises faster than MRP L 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: People rise to level of incompetence – Much time may be spent lobbying managers for promotions 15

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 16

Indifference Curves Between Salaries and Fringe Benefits Fringe Benefits Monetary Compensation Utility = U 1 Utility = U 2 17

Iso-Cost Lines Between Salaries and Fringe Benefits Fringe Benefits Monetary Compensation Slope = -1 Iso-cost line at $50,000 ($50K) of total payment $50 K 18

Optimal combination: Salaries and Fringe Benefits Fringe Benefits Monetary Compensation $50 K $20K $30K 19

Fringe Benefits Payroll taxes – 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. 20