ECON 308: Employment Decisions

Chapter 14

Attracting and retaining qualified employees

Week 13: April 19 , 2010

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Attracting & Retaining Employees

• Principles:– Maximum Value: Marginal Revenue Product

(willing to pay)– People won’t come to your firm until you make

them at least as well of as the could be elsewhere (Opportunity Cost: Have to pay)

– Paying more than is needed to attract employees puts a firm at a competitive disadvantage

– It is in the interest of both employee and firm to maximized the value created in the relationship

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Chapter 14 Organization

• No-frills Competitive Labor Market• Some complications

– Human Capital– Compensating Differentials– Costly Information– Internal Labor Markets– The Salary-Fringe Benefit Mix

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No-Frills Competitive Model

• Labor market is competitive – no discretion over wages

• Market Wages are costless to observe• Workers are identical• Jobs are identical• All labor is rented on the spot market• All compensation is monetary

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Basic Competitive Model

Number of Employees

E

Wag

e in

$

Marginal Revenue Product of labor

Market Wage Rate

E*

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Human Capital

• Terminology– Human Capital: Skills– Investment in Human Capital: Education, OJT– “rate of return” on Human Capital: MB > MC

• Types of Human Capital– General (Excel, Word, text messaging)– Firm Specific: (proprietary software)

6

Compensating Differentials

• Consider 3 Welding jobs– Job X pays $8/hour in clean, air-conditioned

safe working conditions, – Job Y pays $8/hour in a dirty, outdoor

construction site,– Job Z pays $8/hour in ship construction

yard.• Is this an equilibrium wage?

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Compensating Differentials

• Must pay more when a job has undesirable characteristics– $20-300 more must by paid for every 1/10,000

increase in the probability of being killed on the job

– A firm with 1,000 employees could reduce wages by $20,000-$300,000 per year by preventing one accidental death every 10 years.

• Knowledge of necessary CD how to invest in alternatives: safety devices

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Compensating Differentials

• Implications–Unpleasant jobs get done–Companies are rewarded for making

jobs more pleasant–Workers may choose the level of risk

they wish to face

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Compensation Information: Costly to acquire

• Compensation may be hard to see– Workers differ in human capital so they may

differ in the compensation offered– Firms don’t share all of the details of

compensation with prospective employees• Symptoms…

– …of over-paying: too many qualified applicants– …of under-paying: few applicants, high

turnover

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Problems with under-paying

• Low compensation is associated with high turnover so costs of re-training are high

• When turnover is high there may be incentive problems

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Internal Labor Markets

• Hire at entry level, promote from within– Law Firms, Accounting Firms, Hospitals– In 1991 an employee between 45 & 54 had

typically been with the same employer for 10 years or longer

– Half of all men and ¼ of women stay with the same firm at least 20 years

• Most Internal Labor Markets rely on implicit contracts

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Tradeoffs in Long-TermEmployee Agreements

• Benefits of internal labor markets– Accumulates more firm-specific human capital– Better motivation– There is incentive to avoid behavior that is

dysfunctional in the long run– Managers know more about employee attributes

• Costs of internal labor markets– Restricted competition for advanced jobs

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Pay in Internal Labor Markets

Tenure with the firm

SalaryCompensation

Marginal RevenueProduct of Labor

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Tradeoffs with Career Earnings• Advantages

– Efficiency wages reduce turnover and shirking– Since pay rises faster than MRPL employees have strong

incentives to make the firm look good– Promotions become a reward for good behavior

• Disadvantages– Promotions may be manipulated because of destructive

behavior toward other rivals– Promotions are a crude incentive tool since they are

infrequent– The Peter Principle: People rise to level of incompetence– Much time may be spent lobbying managers for promotions

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The Salary-Fringe Benefit Mix

• Fringe Benefits account for about 25% of compensation for the average American

• Examples– Health Insurance– Non-Social Security pension programs– Subsidized Education– Discounted Meals

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Indifference Curves Between Salaries and Fringe Benefits

Fringe Benefits

Mon

etar

y C

ompe

nsat

ion

Utility = U1

Utility = U2

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Iso-Cost Lines Between Salaries and Fringe Benefits

Fringe Benefits

Mon

etar

y C

ompe

nsat

ion

Slope = -1

Iso-cost line at $50,000 ($50K) of total payment$50 K

$50K

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Optimal combination: Salaries and Fringe Benefits

Fringe Benefits

Mon

etar

y C

ompe

nsat

ion

$50 K

$50K$20K

$30K

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Fringe Benefits

• Payroll taxes– Make the iso-cost line flatter– The total tax-bill (including the part paid by the

employees) will matter in determining the optimal mix of fringe benefits

• Applications– Fringe benefits can be used to screen for particular

types of employees– Cafeteria-style plans are desirable when

administration costs are low and when adverse selection is not a problem.

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