ECON 447 Economics of the Workplace

Study Guide (CH 1-5)

CH 1 Setting Hiring Standards

1. Risky Workers Example
(1) Valuing risky candidates: Employees as real options
The option value is higher when:

• The riskier the candidate (holding expected productivity constant)

o Example: young candidates with less experience; new positions
• The downside is smaller:
o the cost of poor performance is small.
o termination costs are low
• The upside potential is higher:
o the potential profits the candidates can bring are huge.
o Example: creative jobs with high upside potential
The option value is also affected by:

• Length of evaluation: the quicker the true performance of the risky worker be determined, the
higher the value.
• Length of employment: The longer the job tenure, the higher the value. (Longer job tenure: the
younger the new hire, the lower turnover in the company.)
• Level of risk aversion
(2) How can firms continue gaining benefits from risky hires when turn out to be stars since their market
value (eventually) rises? Firms can still make profits from the stars by offer a pay level lower than their
productivity because:

• switching jobs is costly to workers

• stars are not easily identified by competitors (Asymmetric Information)
• productivity is firm-specific
2. Hiring in Practice

• In practice, managers are often reluctant to hire risky candidates … Why?

• If you are a risky candidate, what might you do during the interview / negotiation?
• Is there anything that firms can do to encourage hiring risky workers?
3. Setting Hiring Standards
(1) Compare cost-effectiveness (Cheap labor is not Low-cost labor)
(2) Productivity may be dependent on workers or capital

• Productivity is independent of coworkers: Simply choosing lowest cost per unit of output.
• Productivity depends on coworkers: The number of HS and college grads depend on each other.
 • Productivity depends on capital (independent on coworkers): The optimal level of skill rises as
the use of capital relative to labor increases.
4. How Many Workers to Hire
(1) Concepts: Marginal Product of Labor (differs from Average Product of Labor); Diminishing Returns.
(2) Profits are maximized when the value of marginal product of labor equals the wage rate (or marginal
costs of labor).
5. Conducting Experiment

• The Experimental Ideal

• Pretest and post-test with a control group

CH 2 Recruitment
1. Positive mistakes in hiring decisions: false positive and false negative errors.

• What kind of jobs really concern about false positives? False negatives?
2. Concepts: adverse selection; self-selection; screening
3. Screening job applicants
(1) Use credentials in application process.

• Commonly used credentials: Education (degree, quality of school/program); Job experience

• Criteria for a good (useful!) credential:
o Correlated with actual job performance.
o Obtaining the credential is relatively easy for well-qualified workers, but very difficult
for poorly qualified workers. (better signal of ability).
o Rewards for obtaining the credential are not large enough to induce the low-ability type
to obtain.
• When should you invest more resources in careful screening? (screening bankers example)
• the screening method (test) is more effective: more accurate, cheaper, discriminating.
• the stakes are higher: e.g., the wage is higher; the downside from hiring a poor candidate is
worse; the upside from hiring a good candidate is better; the employees are expected to work at
the firm for long time.
(2) Use probation

• Most screening methods are imperfect. The most accurate screen is actual job performance ---
using probation. However, when termination costs are high, the benefits from probation are
reduced significantly.
• Alternative form of probation: temps (pseudo probation during temporary employment)
4. Signaling
(1) Key question: As an employer, how to structure the job offer to encourage the most talented to apply?
 • How to structure the job offer (different wage rates before and after probation) for positive
selection? (refer to the handout and recall the conditions that W1 and W2 should meet).
(2) The probation model is a special case of signaling.

• You’re talented & want to prove it: Invest in a signal of your ability. The signal must be cheaper
(easier) for high-skilled to obtain.
• In probation, the signal is willingness to accept W1 < WE
• Other examples of signaling: Offering warranty on a used car; Requiring entrepreneurs to put
“skin in the game”; Requiring partners to invest in joint ventures; Accepting compensation with
strong pay for performance.
(3) Which firms are more likely to use signaling:

• Jobs where skills are most important.

• Little information available about job applicants.

CH 3 Training
1. Human Capital and Human Capital Theory
(1) Human Capital: refers to knowledge, skills, abilities and other characteristics (KSAO) that people
have in producing economic value.
(2) Human Capital Theory:

• Gary Becker: to understand people’s decision about acquiring education or skills.

• Human capital theory focuses on investment and returns when people invest in education
programs.
• Human capital theory views the acquisition of knowledge as an investment. The payoff in the
later period is in the form of money, job satisfaction, job security, prestige, etc.
(3) Formal education and on-the-job training to obtain human capital
2. Return to education
(1) Investments in Education: should be made if the present value of future earnings exceeds the present
value of the costs of finishing certain education.

• Benefits from a college degree: Increased future income

• Costs: Direct costs of going to college + Forgone income while receiving education
* Use present value of future benefits and costs for an appropriate comparison
(2) Factors affecting returns to education:

• The timing of costs and payoffs.

• The magnitude of costs and payoffs.
o Costs: Tuition; Student financial aid
o Payoffs: Individual ability
 • The length of time the returns are earned (e.g., Age when the investment is made).
• Capital intensity of the job
• How risky are the returns
• Whether the skills will become obsolete and how soon
• Individual interest (discount) rate
(3) Evidence of returns to education: The “ability bias” in the studies on return to education. (The “Twins
Study”)
(4) Increased income inequality in the US:

• Skill-biased technological change (Returns to skill investments have risen dramatically since
about 1980).
• Globalization
• Decline of unionization
3. Important features of the age-earnings profiles:

• Earnings rise over the life cycle.

• Earnings increase at a decreasing rate (earnings become flatter with age)
• Earnings increase faster for more educated workers.
4. Concepts of general human capital and firm-specific human capital; general training and firm-specific
training
5. Who should pay for training?
(1) General training

• If skills are completely general human capital, the worker should pay for 100 percent of the
investment and receive 100 percent of the benefits.
• However, we do see exceptions. Some firms may pay for general training because of:
o Recruiting: Education or training benefits may improve recruiting self selection.
o Employees may pay indirectly, through lower pay.
o Develop the employees who are a strong match to the firm for future leadership role.
o Tax arbitrage.
o Industry pay leader.
o Marketing & branding.
(2) Firm-specific training

• Holdup problem
• Firms and workers split the investment in firm-specific training, and split the returns from the
training.
6. Employee Noncompete Agreement

• One way to reduce risk of employee holdup.

• Possible clauses
o require adequate notice before leaving
o require to describe new employer, job duties
 o require to train successor; introduce to clients
o prohibit from recruiting colleagues to leave as well
o tie vesting to non-compete performance after leaving
• Restricting outside options imposes a cost on employee:
o compensate through higher salary or signing bonus when making offer
o if non-compete signed after employment starts, compensate with lump sum
7. Implications of on-the-job training:

• How costly turnover is to the firm and the worker.

• Workers will be willing to invest in FSHC when they perceive a good match & low turnover
chances.
• Compensation rises with FSHC
• Labor market “thickness”
• Firm size: workers tend to invest more in FSHC in large firms.
8. Evidence of the importance of firm-specific human capital

• Altonji & Williams (2005): ten years of tenure raises log wages by 0.11.
• Jacobson et. al. (1993): longer-tenured workers separating from distressed firms experienced
larger decreases in wages from new employment. In addition, wage drops biggest for those who
have to change industries.
• Kwon and Milgrom (2014): Firm and occupation specific human capital – the value of occupation
specific human capital is positively associated with the level of education within each occupation.
9. Relationship-specific investment: An investment that has no value unless the parties to the transaction
continue their working relationship.

• Holdup problem is the major concern where there is relationship-specific investment.

CH 4 Turnover
1. Reason for turnover: Matching; Technical change; Organizational change; Hierarchical structure
2. Turnover is costly to both firms and employees when human capital is firm specific.
3. Retention strategies:

• Increase compensation
• Compensation tied to (long-run) firm performance: stocks and options.
• Treating key employees as partners (professional service firms are organized into partnership).
• Nonmonetary reward (benefits, flexible hours, new opportunities)
• Early promotion
4. Reducing costs of turnover

• Non-compete agreements
• Knowledge sharing by collaboration
• Cross-training
• Standardize job
 • Knowledge management
5. Bidding for employees
(1) Major problem: Asymmetric information & firm-specific knowledge and skills

• Current employer knows more about the productivity of its employees than the knowledge you
have about their productivity in your firm.
• To hire someone from another firm, you need to be willing to pay more than the current employer
is willing to pay to keep the employee: You can only successfully hire employees that other firms
don’t want to keep. --- Winner’s Curse
(2) When is Raiding Worthwhile?

• The raider must be certain that the target worker’s value is greater to the raider than the worker’s
current firm.
o A worker has very rare and special skills that are a particularly good match with an
employer other than the current one.
o Sometimes a worker is undervalued in current firm.
o Something changed recently, reducing a worker’s value at the current firm, or increasing
it at other firms:
▪ Workers just obtained new skills or credential (e.g., MBA)
▪ Employed in a declining firm / industry
▪ Industry is undergoing rapid technical change.
• The worker’s current firm does not overvalue and therefore does not overpay the worker.
6. Who to target for layoffs?
Based on gap between wage and their productivity. Firm specific human capital is key to this
determination: When firm-specific human capital is important, the firm maximized its profits by laying off
from both ends of the age distribution first. These are the workers who have recently started with the firm
and those who are nearing retirement.
7. Who to target for buyouts?
(1) The firm wants to buy out anyone for whom the present value of wages exceeds the present value of
output. Unfortunately, the individuals who the firm would like to get rid of are not always the ones for
which a buyout is possible.
(2) Be aware of possible adverse selection.
(3) Buyout formulas

• Worker will accept a buyout if: PV(A)+buyout > PV(W), or, buyout > PV(W)-PV(A)
• Profit to the firm from having the worker leave: PV(W)-PV(K)
o If PV(W) – PV(K) >0, the firm would like the worker to leave.
o PV(W) – PV(K) = maximum profitable buyout that the firm can offer
• A deal is possible if: PV(W)-PV(K) > PV(W)-PV(A), or: PV(A) > PV(K)
8. Implementation Plans of Buyouts

• Window plans
 • Retirement bridges
• Job placement services

CH5 Decision Making

1. The organization of an economy: markets and central planning
2. Market failures: There can be a role for government (centralization) because of “market failures”.

• economies of scale implying natural monopoly

• public good
• positive or negative externalities
• set a standard if an industry has positive “network externalities” (e.g., fax machine protocols)
3. Friedrich von Hayek: markets are more effective than Central Planning

• markets make better use of local knowledge through decentralization

• prices provide substantial coordination, without central planning (because price = marginal value
of the good in its best alternative use).
• markets provide strong incentives for efficient resource allocation
• in addition, markets also encourage innovation and adaptation.
4. Market Metaphor for Organizational Design
(1) Firm should utilize market mechanisms in the design of its internal organization, wherever practicable.
(2) Your organizational design needs to:

• use local knowledge for effective decision making

• encourages good coordination (self-organizing)
• provides strong incentives

Calculation (Please refer to the in-class handouts and exercises for more details):
1. How Many Workers to Hire
(1) Be able to calculate the value of the marginal product of workers, and the value of the average product
of workers.
(2) Be able to determine the optimal number of workers that firms should hire in order to maximize profits.
(3) Be able to calculate total profits.

2. Should you Invest More Resources in Careful Screening?

(1) Be able to calculate the expected productivity of job candidates after screening.
(2) Be able to calculate the screening costs for each new hire (note: not for each candidate).
(3) Be able to calculate firms’ profits with/without screening, and determine whether screening is
worthwhile.
3. How can You Structure a Job Offer to Encourage Positive Selection?
(1) Be able to use mathematical expressions to describe the four conditions that W1 (wages during
probation) and W2 (wages after probation) should meet in order to make the job offer attractive to higher
productivity worker but not lower productivity worker.
(2) Be able to explain the rationale for each condition.
4. Buyouts
(1) Be able to determine the minimum buyout prices that firms have to offer to the employees.
(2) Be able to calculate the profits/losses to the firm from having employees leave (this can also be
expressed as the profits/losses from having employees stay).
(3) Be able to determine for which employees it is possible for the firm to make a buyout offer that the
employees will accept; as well as for which employees the firm is losing money on but cannot reach a
buyout deal.