1. Labor Markets Attracting and Retaining Qualified Employees Chapter 14
Incentive Compensation:
Safelite (A)

2. competitive labor market current market wages costless to determine
Perfectly competitive labor market (Benchmark model ) of employment and compensation
Assumptions
competitive labor market
wages determined by supply and demand
current market wages costless to determine
all jobs identical
no long-term contracts
all labor hired in “spot” market
all compensation is monetary

3. Value of labor Compute MP of each checkout person (lane)
If revenue net of cost of goods per customer is $25, compute MRP (marginal revenue product) – the revenue each new checkout lane brings in
If wage is $30, how many lanes to open?

4. Demand for labor in benchmark model
MRP = MP x P
Each firm hires to point where
MRP=market wage
Labor demand satisfies this equality
Labor earns its marginal (revenue) product
The Labor Theory of Value (Marx) is completely false.
Productivity growth raises workers’ MRP, which raises workers’ wages.

5. Managerial implications
If you pay less than market wage, can’t fill positions
If you pay more than market wage, you’re at a cost disadvantage

6. Perfectly Competitive Model wage determination

7. Relaxing the benchmark assumptions
All jobs are not identical
employees will choose most desirable job for given level of pay
firms must offer compensation for undesirable characteristics (compensating differential)
Workers are not perfect substitutes
Information is costly
Compensation takes many forms
Jobs may be long term

8. Human Capital Specific Vs General
Decision to invest depends on Net Present Value of costs and benefits
Firms have little incentive to invest in general and employees have little incentive to invest if firm specific
Usually increase with tenure => Wages usually increase with tenure
Education can be a screening device

9. Average Annual earnings by Educational Attainment

10. Labor Market Turnover Costly to both employees and firms
Loss of specific human capital
Hiring costs - search and training
Most separations come from workers with little tenure
Match Capital - Incomplete information when someone is hired, Good matches are more likely to survive.

11. Internal Labor Markets
Some non-entry jobs may be filled by individuals from within the organization
This is the “internal labor market”
Long-term relationships with employees
Often governed by “implicit contracts” – informal understandings
Increase investment in Human Capital
Help to generate “Match Capital”

12. Long term employment Compensation typically rises with seniority
higher productivity (MRP)
Maybe compensation rises faster than productivity (MRP) -
incentive to work in best interest of firm, acquire firm-specific human capital
Risky for employees – is the firm viable?

13. Upward sloping earnings profile
Bad Cops, Bad Cops
Or Good Cops?
Why do Cops receive relatively generous retirement pay?

14. Compensation components salary plus benefits
Salary and benefit compensation are not perfect substitutes for employees
the role of taxes
groups may purchase benefits at lower price
Benefits inflexible; salary flexible (in use)
Employees may wish to trade between salary and benefits to attain optimum combination

15. Benefits in U.S. Employee Benefits = 29.2 % of Total Comp.
Among Large Employers, 1993
Legally required payments (SSI, etc.)
Retirement
Insurance
Paid Rest, vacations, sick leave, etc.
Miscellaneous (perks, etc.) 
Source: U.S. Chamber of Commerce, Employee Benefits 1993

16. Optimal mix between salary and benefits

17. Optimal choice of salary and benefits with taxes
“With less than two months until the end of the year -- traditional bonus paying time -- executives at the securities firms and recruiters who work with them predict bonuses will increase by an average of 10% to 20% compared with a year earlier. Though that likely will still leave them far below the go-go times of a few years ago, it could nonetheless mark a turning point in fortunes for the battered securities industry. “

18. Risk and incentive compensation
Factors outside employees’ control
Risk aversion
=> incentive pay contracts must balance motivation vs. risk bearing
Examples
CEO performance: bonuses, stock options
Professors: 1700’s – universities gave fees to professors for attracting more students
Weather forecasters: Kursk, USSR: bonuses tied to % of accurate forecasts
Columbus: Spain monarchy entitled him to 10% of “all gold, gems, …tax free”
Salespeople: paid on commission
Lincoln Electric and Safelite

19. Basic principal-agent model
Effort not directly observable – use proxy
“post contractual asymmetric information”
Outside risk factor
Could work hard but not all measured
=> Compensation contract
tie incentive pay to proxy to motivate effort
Include base pay to reduce risk bearing

20. Basic principal-agent model Risk
If replace some base pay with variable compensation
More variability in pay; increased risk
Must give higher expected compensation (“compensating differential”)

22. Safelite Glass 600 small auto-glass repair centers
1994 – pay for performance introduced
Hourly wages = f(base salary, glass installed)
Minimum base salary = $11/hr
Must install defectives without pay
Benefits: TBA
Costs: TBA
Net effect: TBA
Source: E. Lazear, “Performance Pay and Productivity,” The American Economic Review, Dec. 2000

23. Safelite Glass Why was the productivity of Safelite installers so low?
What is PPP trying to accomplish?
What are the likely consequences of a switch from wage rates to piece rates for:
Turnover
Recruitment
Productivity
Product Quality
Total Labor Costs
(How) will PPP succeed?
What are the potential pitfalls in PPP?
Should management proceed with the introduction of PPP or even a modified PPP?

24. Looking Forward November 29,30 and December 2 Incentive Compensation
Chapters 15
Case Readings: Safelite (B)
Course project presentations and discussions
December 6, 7, and 9
Performance Evaluation
Chapters 16 and 17, Arthur Anderson
Final Project Due
December 13, 14, and 16
Final Exam