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Lecture Slides (Alternative Pay Schemes)

The document discusses alternative pay schemes that firms can use including fixed wages, fringe benefits, and incentive pay plans. It also discusses approaches to solving the principal-agent problem between firms and workers, such as pay-for-performance, supervision, efficiency wages, and deferred payment schemes.

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Low Wai Leong
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57 views

Lecture Slides (Alternative Pay Schemes)

The document discusses alternative pay schemes that firms can use including fixed wages, fringe benefits, and incentive pay plans. It also discusses approaches to solving the principal-agent problem between firms and workers, such as pay-for-performance, supervision, efficiency wages, and deferred payment schemes.

Uploaded by

Low Wai Leong
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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ECW 2141

Alternative Pay
schemes
Alternative pay schemes
and labour efficiency

ECW2141 | Dr Lilian Chan 2


Pay schemes
■ Firms want to maximize profits and reduce labour-turnover, while
workers want a high pay for the least effort.

■ The composition of the total pay scheme can affect employee


performance and worker-turnover.
– Fixed wages / salary
– Fringe benefits
– Incentive-pay-plans

■ Firms generally use compensation as a tool to:


– Recruit and retain qualified employees,
– Increase or maintain worker-morale,
– Reward and encourage peak worker-performance,
– Reduce worker-turnover.
ECW2141 | Dr Lilian Chan 3
Pay schemes
■ Types of compensation can include:
– Basic pay
– Overtime pay
– Commissions
– Bonus, profit-sharing
– Stock options
– Travel / Meal / Housing allowance
– Dental / Medical / Insurance
– Annual leave, Sabbatical
– Employee Retirement Fund (e.g. EPF)
– etc.

ECW2141 | Dr Lilian Chan 4


Fringe benefits
■ Fringe benefits are a form of compensation (to the
employee) apart from the stated wage or salary.

■ Common examples of fringe benefits include


• medical/dental insurance,
• paid vacation,
• sick days,
• housing allowance,
• education-related assistance,
• retirement and saving benefits,
• etc.

ECW2141 | Dr Lilian Chan 5


Fringe benefits
■ Firms use fringe benefits attract and retain high-quality
workers, and protect their training investments because they
tie workers to jobs and hence reduce resignations.

■ Fringe benefits confer tax advantages to the worker, and also


to the employer.

■ In the US, fringe benefits tend to be larger (as a proportion of


total compensation) in high-paying industries, and for blue-
collar workers.

ECW2141 | Dr Lilian Chan 6


The principal-agent problem
■ The relationship between firms and workers can be subject
to the principal-agent problem – which affects the
relationship between pay and performance.
— Agents (i.e. workers) pursue some of their own objectives that
conflict with the goals of the principals (i.e. firms), e.g. shirking.
— Therefore, firms have a profit incentive to reduce (or, eliminate)
principal-agent problems.

■ There are several ways to solve the principal-agent problem,


depending on:
– whether individual workers’ output is easily measured,
– whether supervision of workers is cost-effective.

ECW2141 | Dr Lilian Chan 7


Pay-for-performance
■ Where individual workers’ output can be readily measured,
one way to solve the principal-agent problem is to tie pay
directly to output or performance, e.g. incentive pay plans.
– Piece rates
– Commissions and royalties
– Raises and promotions
– Bonuses
– Profit sharing
– Equity compensation
– Tournament pay

ECW2141 | Dr Lilian Chan 8


Supervision
■ Another way to solve the principal-agent problem is for the
principal (i.e. firm) to directly observe the agent’s (i.e.
worker’s) actions on the job.

■ Firms can reduce shirking by monitoring the efforts of


workers (e.g. by hiring supervisors).

■ Workers will not shirk for fear of losing their jobs – however,
monitoring can be costly to the firm.

■ In some circumstances, the cost of monitoring may not


economically viable (i.e. where the costs outweigh the
benefits).

ECW2141 | Dr Lilian Chan 9


Efficiency wage payments
■ In cases where a worker’s output is difficult to measure, and
where monitoring a worker’s effort is not cost-effective, another
approach to solving the principal-agent problem is to pay workers a
wage that is above the market-clearing level.

■ Efficiency wage theories propose that wage increases may increase


productivity. Therefore, any increase in wage will shift the labour
demand curve to the right.

■ An efficiency wage is one that minimizes an employer’s wage cost per


effective unit of labour service employed.

■ Under assumptions that labour is heterogeneous and wage-productivity


dependent, it is possible for a firm to lower its wage cost per effective
unit of labour service by paying a higher wage rate.
ECW2141 | Dr Lilian Chan 10
Efficiency wage theories
1) Shirking model
• The rise in wages will increase the opportunity cost of being
terminated for shirking.
• Shirking is reduced, and worker-productivity rises.

2) Nutritional model
• The rise in real wages might increase the nutritional and health
levels of workers.
• Healthier workers are more alert and more productive.

3) Labour turnover model


• The rise in wages reduce the rate of job resignations, and therefore
reduces the firm’s turnover costs.
• Workers that stay on the job longer are more proficient (“learn by
doing”) and therefore more productive than new replacements.
ECW2141 | Dr Lilian Chan 11
Ef ficiency wage ef fects
Wage
rate, ω

unemployment SL1
ω2
b c

ω1 a

DL2
DL1
0 L1 L2 Quantity of
labour (hours)

ECW2141 | Dr Lilian Chan 12


Ef ficiency wage theories –
implications and criticisms
■ Permanent unemployment may exist under conditions of equilibrium in
labour markets.

■ This contributes to the reason for the wage-productivity dependence in


the shirking model – because the unemployed workers serve as a
credible threat to being caught shirking, and encourages full-effort.

■ Detractors of efficiency wage theories point out that:


– Pay-for-performance plans could serve as alternatives to guard against
poor worker-effort.
– A firm could require employees to post a bond that they would forfeit if
they were found shirking or negligent in their job duties.
– A worker’s pay could be deferred until later years, or until employees
qualify for pensions.
ECW2141 | Dr Lilian Chan 13
Deferred payment schemes
■ Firms and workers may enter into
Wage rate,
implicit contracts that wages increase ω
with years of service.

■ Younger (or, newer) workers are paid


less than their MRPL, while older Wage
workers are paid more than their
MRPL.
MRPL
assumed constant
■ The prospect of higher pay at the end
of one’s career may discourage
shirking and reduce turnover — which
is likely to increase their productivity
at work.
0 Quantity of
■ It is possible for a worker to earn a labour (hours)
higher lifetime income than if wages
equaled MRPL each year.

ECW2141 | Dr Lilian Chan 14


Deferred payment schemes
■ With deferred pay contracts, workers may prefer to retire at a later
age due to the higher pay. However, firms have an incentive to fire
older workers because their wages exceed their MRPL.

■ This problem can be solved by providing generous pensions if the


worker retires within a certain age-range.

■ Deferred pay contracts are more likely in large and established


firms, because:
– Workers may be more difficult to monitor in large firms.
– Large firms are less likely to go bankrupt. Therefore, younger
workers are more willing to accept a deferred-pay contract.
– Large firms are less likely to renege on a deferred-pay contract (and
ruin their reputation) by firing older workers.

ECW2141 | Dr Lilian Chan 15

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