1. Alternative Pay Schemes and Labor Efficiency

2. Fringe benefits
Total compensation of employees = wages + fringe benefits
Fringe benefits = public programs(like social security) +
private programs(like medical and dental, pensions, paid
vacation and sick leave).
About 72% of compensation is in wages and 28% is in fringes.
In 1955 fringes made up about 15% of compensation.

3. Optimal fringe benefit theory
To understand why something like fringe benefits has
changed in our economy, economists come up with
theories. The theory we will look at is a modification of
the labor leisure model we saw earlier.
Our theory will have indifference curves and a budget
constraint.

4. Indifference curves
Remember that an indifference curve shows combinations of goods that yield the same level of utility for the
individual. The goods we are talking about here are wages
and fringe benefits.
The indifference curves for an individual summarize their
subjective view about the trade-off between wages and
fringe benefits.
Some have wondered why fringe benefits would be of
interest to people. It seems that a dollar in fringe benefits is
less beneficial than a cash equivalent. As an analogy
consider the following: Which would you rather I give you,
a snicker bar or the money amount of the snicker? With the
money you could buy the snicker bar or something else, if
that made you happier.

5. Indifference curves There are two reasons fringe benefits (FBI) may be
traded-off with wages:
1) tax advantages
2) may be the only way we ‘buy’ some things

6. tax advantage
Example
Say a worker has no FBI, has 30,000 in income, the first
20,000 of which is taxed at 15% and the rest at 28% and
the worker puts 2,000 into retirement.
The tax for the worker is 20,000(.15)+10,000(.28) = 5,800.
After taxes and retirement the worker has 22,200 left to
spend.
Now say a worker has FBI in that 2000 can be put into
retirement before it is taxed as income.
The tax for the worker is 20,000(.15) (.28) = 5240 and
after the tax and retirement the worker has 22,760 left
to spend.
The fringe leads to 560 tax decrease. Maybe we would
trade FBI for wages.

7. ‘buy’ what is good for us
For many of us we get paid and that money is spent before
our next paycheck - we enjoy the good life.
We are willing to give up wages because
we will still enjoy the good – save 10% of all you earn and you probably won’t notice a difference.
we will get some stuff like health care and pension plans that we might not have purchased on our own. Without the fringe benefit we might be like a kid in a candy store and not get exactly what we really should.

8. indifference curve graph
wages
fringe benefits
So the indifference curves are much like we have seen in
the past. They are downward sloping and convex to the
origin.

9. The budget line
The budget line represents what the worker can trade-off
in the market. But here the firm plays a role.
The firm looks at total compensation of employees to
figure what maximum profits might be. If the firm takes
a dollar of wages away and gives a dollar of FBI, its
compensation wouldn’t change. So initially our
understanding of the budget is that for every dollar given
up by firms, a dollar in FBI is returned. W 1 1
FBI

10. The budget line
The budget line can actually rotate counter clockwise if we
consider
1) tax advantages to the employer
2) economies of scale
3) efficiency of labor with fringes.
On the budget line
farther out, the firm can
give back more than a
dollar of FBI when a
dollar of wages is taken
away. W 1 1
FBI

11. tax advantage for employer
Say a worker gets paid 30,000. The firm has to contribute
7.65% of income to social security and medicare.
This means the firm has
to pay 2295 in social security tax. The real cost to the firm is
32295 to have this worker work in the firm.
When FBI are given the dollar value is not subject to social
security taxation. So if the firm takes a dollar of wages
away it can offer the dollar plus the tax saving of 7.65 cents
back in FBI.

12. Economies of scale
If each worker bought their own insurance it would cost
x dollars. With the firm buying a group plan, the group
rate means the worker could get more than x dollars worth
of insurance for the same x dollars if those dollars are now
taken as FBI.
I am a bit skeptical of this argument. If this really is the case,
why don’t we do our car insurance the same way?

13. efficiency All dollars in expense to the firm are not the same. Let’s
us an example to try to see what this means.
case 1
Workers only stay at a company for a year because there
are no FBI.
year 1 $1 in training cost yields x output.
year 2 $1 in training cost yields x output.
case 2
Workers stay longer than a year because of FBI
year 1 $1 of training cost yields x output.
year 2 $1 of FBI yields x+y output.
So workers that stay longer at a firm may become more
productive and thus the firm can offer more than a dollar in FBI for every dollar of wages taken away.

14. optimal amount of FBI W The optimal amount of FBI
occurs where the worker
can get on the highest
indifference curve but still
be on the budget line. This
occurs on curve 2 and the
worker gets the amount of
FBI represented by FB1. 1 2 3
FBI
FB1

15. optimal amount of FBI W Over time as the budget
line has shifted out due to
the ideas mentioned above,
we see the the optimal
amount of FBI has
increased(so have wages). 1 2 3
FBI
FB1 FB2