Variable pay or straight salary

1
Variable pay or straight salary

• University Professors get a straight salary
  which is mainly based on age which might be
  considered high or low, depending on your point
  of view.
• Should we introduce incentive pay, e.g. by of
  exams or scientific papers written
• What are the tasks of academics?
• What about fixed jobs without layoff risk?
• What are problems of incentive pay?

2
Incentive pay

• Should pay be based on input or output?
• How should output be defined?
• Does paying for output cause workers to seek the
  wrong goals?
• Does output-based compensation induce people to
  focus on the short-run only?
• Should it be tied to individual or group output?

3
Why choose output based pay?

• Positive influence on hiring and retention
• also known as adverse selection
• low ability workers will look for jobs that pay
  by input rather than output
• workers who do not want to work hard are likely
  to leave the firm.

• If you can sell gt 5, you go to thecompany with
  output based pay. If lt 5 you go to the flat base
  pay

4
Example taxi drivers

• Driver rents the car, pays for gas and keeps all
  revenues
• or
• Company gives the driver the cab, pays for gas
  and they split the revenues 5050
• Some problems with second scheme???
• Moral hazard on the side of the driver
• Efffort of driver is sub-optimal

5
Agency Theory or Principle-Agent-Model

• Implicit assumptions
• Worker is averse to effort E (otherwise
  everything is just fine)
• Worker is averse to risk (otherwise the problem
  is simple)
• The parties cannot contract on the level of
  effort E (otherwise they would write a contract
  on e, leaving the employer all the risk)

6
A simple model with risk neutrality

• Disutility of effort E is C(E) i.e. the worker
  does not exert effort E0 unless he gets at least
  C(E0) paid.
• How does the worker choose effort optimally to
  max his utility
• total compensation (risk neutral!!) minus effort
  cost
• gt marginal effort cost should be equal to
  marginal return for effort

7
How does the firm choose ? and ? ?

• Firm will try to maximize profits, but has to
  check
• Choice of ? will determine Effort E
• Total compensation must be high enough to keep
  the worker with the firm, i.e.
• Assume E is equal to output also
• gt
• gt

8
Surprising result worker should get the whole
additional output

• If risk-neutral worker should act as residual
  claimant worker acts like an entrepreneur
• Only this contract will allow the optimal choice
  of effort
• How does the firm make profit in this case?
• gt choose ? as high as possible, so that profit
  increases, but worker should be willing to sign
  the contract!

9
Example salespersons commission

• Marginal cost for computers 900
• Market price 1000
• Optimal commission is 100 per piece sold.
• Optimal for worker as it seems, but is this
  really optimal for the firm???

10
Findings at Safelite Glass Corporation

• (Based on Lazear, E.P., Performance pay and
  productivity, American Economic Review, 2000,
  1346-1361)
• switch from salaries to piece rates induced a 36
  increase in productivity
• about 2/3 of this is due to incentives, rest is
  due to changing composition of the workforce
• Pay increased by 9
• Remarks about Quality and External validity

11
Why dont you see workers often paying for their
jobs?

• Principle idea 100 commission rate, and worker
  has to pay in order to get the job
• No explicit payment, but implicit
• Is it better to have, say, 10 in sales or 100
  in profits?
• Moral hazard on the side of the firm!
• Capital market imperfections do not allow buying
  the firm, which would be sometimes the best
  solution to maintenance problems

12
Problem gets more complicated in reality and with
risk-aversion of workers

• 1st principle of optimal insurance the party who
  can more easily absorb risk (ie the party that is
  most risk neutral) should insure the other party.
  
• employees are likely to be more risk averse than
  the firm. The firm should not avoid risks if
  avoiding would lead to lower profits.
  Stockholders can diversify risk across
  investments. They want the firm to earn the
  highest profit possible. Therefore the firm
  should insure the employees
• the firm can pay lower wages if it accepts the
  risk
• firms that pay by output will need to pay higher
  compensation. If they do not get greater
  productivity, it is a waste

13
Sometimes output is difficult to measure

• Possible that variations in output are due to
  external factors that are not controllable by the
  employee. Unless the firm can condition on these
  factors it may be difficult to give the proper
  incentives.
• If the work of the employee depends upon
  coordination with other employees, it may be
  difficult to single out their individual
  contribution. It may be necessary to pay on a
  team basis.
• There may be multiple tasks. Incentives must be
  balanced across different tasks. If it is
  difficult to measure the performance on one task,
  strong incentives on other tasks will result in
  the employee ignoring that task. There can be a
  severe problem of distortion of incentives.

14
Equal Compensation Principle

• If the worker has two tasks, either compensate
  effort alike in both, or dont use incentive
  contracts
• Quality versus quantity
• Sales today versus next year...
• University professors do teaching and research

15
It may be difficult to set the rate.

• Workers have incentives to slow down when you are
  attempting to set the appropriate rate.
• Management has the incentive to increase the
  required rate when the workers easily surpass
  their old levels of productivity. This is called
  the ratchet effect. Since workers realize that
  the ratchet effect exists, they will be reluctant
  to work to their full capacities or they may try
  to force other workers to work at less than full
  capacity.

16
In case of risk aversion of workers ...

• The higher the ability of workers, the stronger
  should be incentives.
• The higher the risk aversion among workers, the
  lower the incentives should be.
• The stronger the effect on company profits of
  increased effort by the employee, the greater the
  incentives should be
• The stronger the impact on effort, the greater
  the incentive should be.
• The greater the precision of measurement of
  output, the greater the incentive should be.

17
Different types of pay-performance payment

• Output based measures often involve quotas, bonus
  payments, caps or promotions
• Quotas are very good as long as the workers are
  homogeneous. However, they suffer from the
  problems of discontinuity little incentive if
  there is low prob. of making the quota and little
  incentive after the quota is made.

18
Bonus or Penalty

• Consider 2 different job offers
• Scheme A pays 10,000 per month plus a bonus of
  1 for every unit sold
• Scheme B pays 15,000 per month with a 5,000 unit
  quota penalizing the worker with 1 for every
  unit below the quota
• suppose its not possible to produce more than
  5,000 to make it simple
• What is more attractive for workers?
• Which job offer creates the highest incentives?

19
Whats the psychology behind these schemes?

• only use positive rewards
• Theory of loss aversion (Kahneman and Tversky)
  experiments showing that people hate more to give
  up something they think they own.
• Establish a rule (social norm) you think people
  should obey
• Economic considerations
• Use bonus when there is no cost to poor
  performance
• Use penalty if there is no benefit to high
  performance
• Examples??

20
Performance pay for Managers (CEOs)

• Two views
• CEOs are overpaid board of directors do not
  represent shareholders interests, they also are
  too short-term oriented
• CEOs are worth every nickel they get
• What should CEOs maximize?
• importance of efficient market hypothesis

21
Empirical evidence

• Compensation through stock options in a much
  higher proportion for US CEOs
• Some results for the US
• Pay and firm size 10 extra sales, 2-3 extra
  salary
• pay and performance pay responds to performance
• intensity of incentives largest estimate 3.25
  for 1,000 increase in shareholder value

22
Question

• CEOs often receive a substantial part of their
  compensation as variable pay. It is difficult to
  measure the CEO's performance. You are a
  compensation consultant. To which of the
  following accounting measures do you propose to
  tie executive compensation?
• Change in earnings reported by the company.
• EBIT or change thereof.
• Change in revenues.
• Change in the market value of the company.
• Change in market value relativ to change in Dow
  Jones.

23
Answer

• What you should consider
• Discretion of manager to influence bookkeeping
  figures
• Influence of short- vs. long-term investments
• Is the market valuation rational?
• What does the relative compensation do

24
Question

• Both CEOs and VPs tend to have a certain
  percentage of their compensation tied to the
  companys overall per-formance. Who (VPs or the
  CEO) should have a larger percentage of wages
  tied to the company performance?
• Explain.