1. CHAPTER 11 – Incentive Pay
11-1 Piece Rates an Time Rates
11-2 Tournaments
11-3 PA: Compensation of Executives
11-4 Work Incentives and Delayed Compensation
11-5 Efficiency Wages
Give a brief overview of the presentation. Describe the major focus of the presentation and why it is important.
Introduce each of the major topics.
To provide a road map for the audience, you can repeat this Overview slide throughout the presentation, highlighting the particular topic you will discuss next.

2. Introduction So far, we studied spot labor markets. In each period:
firms decide how many workers to hire at given wages,
workers decide how many hours to work
interaction of both determines the equilibrium: w* & E*
Once the equilibrium wage (w*) is determined, workers and firms make relevant labor decisions.

3. Introduction
This chapter  “the nature” of employment contract between the worker and the firm.
Problem with simple story: Labor market contract affects productivity and the profits (endogeneity)
Different “compensation systems”: Piece-rate vs Time rates
Role of incentive pays to elicit effort

4. 11-1 Pay Systems: Piece Rates
A worker is paid a piece rate if she is paid according to the number of the units of output she produces (i.e. VMPL).
i.e. commission based on volume of sales
Piece rates are used by firms when it is cheap to monitor the output of workers.
Piece-rate compensation systems attract the most able workers and elicit high levels of effort from these workers.

5. The Allocation of Effort by Piece-Rate Workers
The piece rate is r dollars, so the marginal revenue of an additional unit of output equals r.
The worker gets disutility from producing output, as indicated by the upward-sloping marginal cost of effort curve.
The level of effort chosen by a piece-rate worker equates marginal revenue to marginal cost, or q* units.
If it is easier for more-able workers to allocate effort to their jobs, they face lower marginal cost curves and produce more output.
Dollars q* r
Output
qABLE MR MC
MCABLE

6. Pay Systems: Time Rates
A worker is paid a time rate if she is paid a fixed amount per period of time she works, such as being paid an hourly wage.
Time rates are used by firms when it is costly or impossible to monitor the output of workers.

7. Sorting of Workers across Firms
All workers, regardless of their abilities, allocate the same minimal level of effort (qmin) to time-rate jobs.
Because more-able workers find it easier to allocate effort, they will allocate more effort to piece-rate jobs and will have higher earnings and utility.
Workers with more than x* units of ability sort themselves into piece-rate jobs, and less-able workers choose time-rate jobs.
Utility
r*qmin
Ability
Piece-Rate
Workers
Time-Rate
Worker B
Worker A x*

8. Pay Systems: Piece Rates
Advantages of Piece Rates
Attracts most-able workers
Elicits high levels of effort from workforce
Ties pay directly to performance
Minimizes discrimination and nepotism
Increases firm productivity
Why are piece rates not used more often in the market?

9. Pay Systems: Piece Rates
Disadvantages of Piece Rates
When production depends on team effort  Free riding
Workers paid by the piece rates may choose quantity over quality.
Risk-averse individuals may not prefer being paid by piece rates due to higher income volatility potential.
Workers in piece-rate firms fear ratchet effect:
High production levels misinterpreted lower rates
Discourages adoption of more efficient production methods

10. Bonuses, Profit-sharing, and Team Incentives
Unlike piece-rate systems, profit-sharing programs suffer from the incentive problems that afflict all team efforts, particularly the free-riding problem.
Single worker’s pay is distantly related to the productivity of the individual  Not much incentive to allocate effort to job
Evidence suggests that profit-sharing plans increase the firm’s productivity:
Study of US firms: Profit sharing  Productivity by about 4-5%

11. In-class Exercise:
11-3. A firm hires two workers (Charlie and Donna) to assemble bicycles:
The firm values each assembly at $12.
Charlie’s marginal cost of allocating effort to the production process is 4N, where N is the number of bicycles assembled per hour.
Donna’s marginal cost is 6N.
If the firm pays piece rates, what will be each worker’s hourly wage?
Suppose the firm pays a time rate of $15 per hour and fires any worker who does not assemble at least 1.5 bicycles per hour. How many bicycles will each worker assemble in an 8 hour day?

12. 11-2 Tournaments
Some firms award promotions on the basis of the relative ranking of the workers.
Winners in sports events: Olympics, Golf Tournament
Promotion of Executives: Vice Presidents vs CEO
A tournament might be used when it is cheaper to observe the relative ranking of a worker than the absolute level of the worker’s productivity.

13. The Allocation of Effort in a Tournament
The marginal cost curve gives the “pain” of allocating an additional unit of effort to a tournament.
If the prize spread between first and second place is large, the marginal revenue to an additional unit of effort is very high (MRHIGH) and the worker allocates more effort to the tournament.
Dollars
Effort MC
MRHIGH Y X
MRLOW
Fhigh
Flow

14. Sports Competitions and Cheating
Disadvantages of Tournaments
Collusion  Failure to elicit the right level of effort
Sports Competitions and Cheating
Tournaments may encourage too much competition.
A large prize spread creates incentives for workers to sabotage the efforts of other players or to quit along the way.

15. 11-3 PA: Compensation of CEOs
Examples of “tournament” approach in the real world:
Spread between CEO and vice presidents
Principal-Agent Problem
Agent (CEO) vs Principal (Firm)
Firm’s goal: Maximize firm’s profit and shareholders’ wealth
CEO’s goal: Maximize own utility  Risk taking behavior
There is a positive correlation between the compensation of CEOs and firm’s performance, but the correlation is weak.

16. 11-4 Work Incentives & Delayed Compensation
Delayed-compensation contract:
Firms offer the worker a contract where wage is below the VMP in the initial years of employment and vice versa.
Delaying the compensation of workers until later in the life cycle…
results in upward-sloping age-earnings profiles
(alterative story to the Human Capital model)
encourages them to allocate more effort to the firm.

17. Indifference Between a Constant Wage and Upward-Sloping Age-Earning Profile
Earnings C D B A N t*
Years on the Job
VMP
If the firm could monitor a worker easily, she would get paid her constant value of marginal product (VMP) over the life cycle.
If it is difficult to monitor output, workers will shirk. An upward-sloping age-earnings profile (such as AC) discourages workers from shirking.
Workers get paid less than their value of marginal product during the first few years on the job, and this “loan” is repaid in later years.

18. 11-4 Work Incentives & Delayed Compensation
Delaying the compensation of workers until later in the life cycle…
results in upward-sloping age-earnings profiles
(alterative story to the Human Capital model)
encourages them to allocate more effort to the firm.
Discourages shirking (when monitoring is costly) and reduces job turnover
Contributes to the origin of mandatory retirement clauses

19. 11-5 Efficiency Wages
Some firms might want to pay wages above the competitive wage in order to motivate the work force to be more productive.
The efficiency wage is set such that the elasticity of output with respect to the wage is equal to 1.
Efficiency wages create a pool of workers who are involuntarily unemployed.

20. The Determination of the Efficiency Wage
The total product curve indicates how the firm’s output depends on the wage the firm pays its workers.
The efficiency wage maximizes the firm’s profits.
The efficiency wage is given by point X, where the marginal product of the wage (the slope of the total product curve) equals the average product of the wage (the slope of the line from the origin).
Output qe qo Z X Y
Wage we w
Total
Product
Curve q1

21. The Determination of the Efficiency Wage
The production function: q  function of capital & efficient labor.
Total labor costs are w*L
Cost minimization requires finding the lowest total labor costs “C” per efficient worker:
The first-order condition:
Implies the Solow condition:

22. Why Is There a Link between Wages and Productivity?
A high wage makes it costly for workers to shirk (i.e., they lose the wage if caught).
People who are well-paid might work harder even if there is no threat of dismissal.
Efficiency wages reduce the quit rate and increase output and profits.
A firm that pays efficiency wages attracts a more qualified pool of workers, increasing the productivity and profits of the firm.

24. Interindustry Wage Differentials
Efficiency wages hypothesis may potentially explain the huge industry wage differentials:
Metal mining/Railroad earn 30% more than average worker
These wage differentials persist over time.
Competitive model: Differentials exist in the LR due to
differences in job characteristics (pollution), or
differences in unobserved worker traits (ability)
Efficiency wages: Differentials arise (not because of compensation) because firms in high paying industries do so due to the profit maximizing behavior. (monitoring/turnover costs)

25. Interindustry Wage Differentials
Empirical evidence is mixed:
Inter-industry differentials remain even after controlling for job specific factors (risk, pleasantness, etc.)
If differentials were due to ability & self-selection, low wage industries would not have different quit rates (lower) than high wage industries.
However, workers seem to sort themselves across industries.
Empirical testing:
If efficiency wages hypothesis is valid, workers that switch from a low-wage to a high-wage industry should experience large increases.
70% of the differentials are estimated to be due to sorting.

26. Efficiency Wages & Dual Markets
Suppose there are two markets:
Primary sector: Worker’s output is hard to observe and monitoring is costly
Example: software professionals
Compensation scheme: Efficiency wages
Secondary sector: workers perform repetitive tasks, easy to supervise and productivity is monitored constantly
Example: Manufacturing or Sales
Compensation scheme: No efficiency wage

27. Efficiency Wages & Dual Markets
Efficiency wages hypothesis creates segmented labor markets (Dual Labor Markets):
Primary sector: Offers high wages, good working conditions, employment stability and chances for promotion
Secondary sector: Offers low wages, poor working conditions, high turnover, few chances for promotion
In a competitive model: Wage differentials would vanish in time as workers migrate across sectors.
Efficiency wages: Prevent this equilibrating process since primary sector cant lower wages due to possibility of shirking and monitoring is hard/costly.

28. Efficiency Wages & Dual Markets
An important criticism of the efficiency wage model is known as “Bonding critique”:
Firms use a wide variety of compensation schemes (i.e. piece rates, tournaments, etc.) which work within the confines of a competitive market.
Efficiency wages are different since they are determined without regard to market conditions A high paying firm would have too many applicants.
Consequently, competition among workers would lead to workers willing to provide a bond to its potential employer as an insurance towards shirking. Value of the bond (determined in the market) would ensure equalization of wage differentials across firms.
“Efficiency wage models self-destruct in the LR”.

29. Homework:
11-5. Suppose a firm’s technology requires it to hire 100 workers regardless of the wage level. The firm, however, has found that worker productivity is greatly affected by its wage. The historical relationship between the wage level and the firm’s output is given by:
What wage level should a profit-maximizing firm choose?
What happens to the efficiency wage if there is an increase in the demand for the firm’s output?