1. Chapter Eleven Personnel and Compensation

2. Copyright © Houghton Mifflin Company.All rights reserved. 11–2 Principal-Agent Issue Employer -- Employee Customer -- Supplier Manager -- Subordinate CEO -- Middle managers CEO -- Board of directors Shareholders -- Board of directors Shareholders -- CEO

3. Copyright © Houghton Mifflin Company.All rights reserved. 11–3 Principal-Agent Issue What we might call the “Internal Labor Market” is what goes on between managers and employees inside a firm. How, for instance, can the managers ensure their employees are the best out there?

4. Copyright © Houghton Mifflin Company.All rights reserved. 11–4 The Internal Labor Market Efficiency wages: Pay more than opportunity costs. What would this do for the employee? Two things: It would make employees not want to shirk and get fired and They would be attracted to the firm only if they were indeed the best and could meet expectations.

5. Copyright © Houghton Mifflin Company.All rights reserved. 11–5 The Internal Labor Market Compensation profile: a comparison of compensation and productivity or value to the firm.

6. Copyright © Houghton Mifflin Company.All rights reserved. 11–6 Pay Years with Firm What if the compensation pattern over time looked like this?

7. Copyright © Houghton Mifflin Company.All rights reserved. 11–7 The Internal Labor Market Why would compensation rise over time? Perhaps because employees become more valuable to the firm, that is, they become more productive.

8. Copyright © Houghton Mifflin Company.All rights reserved. 11–8 Pay Years with Firm Actually, in most cases, compensation and productivity are different. compensation Compensation/Productivity Profile

9. Copyright © Houghton Mifflin Company.All rights reserved. 11–9 Pay Years with Firm compensation Compensation/Productivity Profile Here, compensation is greater than productivity in later years and less in earlier years productivity

10. This type of relationship between compensation and productivity is called backloaded compensation. What would it mean for an employee to face a backloaded compensation scheme? The employee would want to remain with the firm for many years

11. Copyright © Houghton Mifflin Company.All rights reserved. 11–11 Backloaded Compensation What would downsizing mean if compensation is backloaded? It would send a signal to employees that they might not ever capture their backloaded wages – this could lead to lower quality employees.

12. Copyright © Houghton Mifflin Company.All rights reserved. 11–12 Other Internal Market Characteristics There are efficiency or economic reasons for everything you observe working in a firm. For instance, can you explain: What is the purpose of a bonus? What would you tie a bonus to? What is the purpose of a promotion?

13. Copyright © Houghton Mifflin Company.All rights reserved. 11–13 CEO Compensation For Fortune 500 companies, the average CEO makes 200 times more than the lowest paid employee Many say this is excessive. Is it?

14. Copyright © Houghton Mifflin Company.All rights reserved. 11–14 CEO Compensation Issues to consider: Incentives. Are managers (CEOs) exempt from performance pressures? What can be done if a manager is not performing well----not increasing shareholder value, that is?

15. Copyright © Houghton Mifflin Company.All rights reserved. 11–15 CEO Compensation Issues to consider: Perhaps the board of directors can fire the CEO. What is board of director’s objective? Perhaps the firm can be taken over and the CEO fired. What about golden parachutes, greenmail, or poison pills? Are these efficient or inefficient – explain.

16. Copyright © Houghton Mifflin Company.All rights reserved. 11–16 CEO Compensation What is the role of stock options? How do they tie CEO compensation to the performance of the firm? How did the use of options go so wrong in the early 2000s? The problem was that the link between CEO compensation and firm performance was at best very weak.

17. Copyright © Houghton Mifflin Company.All rights reserved. 11–17 Another Issue in the Internal Labor Market Is the Architecture of the Firm Piece Rate Compensation: An individual is paid according to the amount the individual produces. A great example is Lincoln Electric. When would piece rate compensation not be efficient?

18. Copyright © Houghton Mifflin Company.All rights reserved. 11–18 Another Issue in the Internal Labor Market Is the Architecture of the Firm “Teams are the only way to be successful.” “When people work together, the team spirit spurs individual effort.” What is the situation with teams? What are the incentives of individuals in a team?

19. Copyright © Houghton Mifflin Company.All rights reserved. 11–19 When would teams work and when not? When production is easily tied to individual productivity? When the productivity of the individual is costly to measure?

20. Copyright © Houghton Mifflin Company.All rights reserved. 11–20 Subjective Evaluations This occurs when a superior evaluates someone but the evaluation is not quantitative but more “touchy-feely” or opinionated. Why would subjective evaluations be efficient? To increase cooperation among employees or to create an incentive for behaving in a way that benefits the firm that is not easily measured.

21. Copyright © Houghton Mifflin Company.All rights reserved. 11–21 Risk What happens when an employee’s compensation is based on factors that are not in the control of the employee? There are no incentives to perform. Thus, in circumstances when some of the employee’s compensation is tied to factors beyond the employee’s control, we say the employee is subject to risk (non-diversifiable risk).

22. Copyright © Houghton Mifflin Company.All rights reserved. 11–22 Risk The efficient compensation scheme must reduce the negative incentive effects that occur from risk. The firm must share the risk with the individual. This is one reason that compensation is based on individual performance, team performance, firm performance, and subjective evaluations rather than just on one of these factors.