Compensation and incentives

1
Compensation and incentives
2
Managing compensation A map of concepts and
tools (Baker, Jensen Murphy 88)

• Compensation level
• ? where people work recruitment, turnover
• Compensation composition
• ? the value (cost, utility) of a certain level
• Compensation function
• ? performance

3
Compensation level

• Value of job package
• effort, money, term, human capital, specificity,
  fringe benefits, etc.
• How to set up? Multidimensional, lack of prices ?
  Look at
• turnover
• queues of qualified candidates
• costs and benefits of turnover
• Job rating systems (Hay plans) ? aggravates
  bureaucracy
• Efficiency wages higher than market wages ?
  Two origins
• Market ? compensation level or function?
• Regulation ? rent seeking

4
Compensation composition

• Should not trigger conflict between parties
• Effects on labor relations
• Self-selection e.g., health plans, deferred ?
  low subjective discount rate
• Moral hazard paying with product discourages
  theft
• Self-control pensions, work safety
• Effects on other relations
• Adverse selection reduces transaction costs by
  grouping health insurance
• Moral hazard e.g., easily-to-enforce credit to
  employees
• Tax avoidance by paying in kind
• Growing demand for flexibility
• Demographic variety and change ? Flexible
  compensation
• Marketing view of compensation package selling
  jobs

5
Compensation function (1)

• How compensation level depends on performance
• Basic types of variable compensation
• Piece rates, commissions, bonus plans, etc.
• BUT not only money, not only short term
• Task allocation between subordinates
• Promotions and salary revisions
• Firing and penalties
• Non-vested pensions and deferred compensation

6
Compensation function (2). Effects and
limitations of pay for performance

• Big problem in economics literature, small in
  real life inefficient risk allocation
  (principal-agent model)
• Main real problem produces harder effort and
  smarter effortBUT poses measurement problems
• Gap between performance and contribution to firm
  value
• Quality Moscow taxis MBO and killings of
  civilians in Viet Nam
• Gaming reallocation of performance between
  periods or units
• Externalities
• Sabotage of others in relative performance,
  between shifts ? Pay compression useful to
  enhance cooperation
• Damage to clientele reputation effects
• ? Important to group together activities in which
  performance can be measured in a similar way

7
1st party enforcement
2nd party enforcement
Effort
Performance
Uncertainty
Firm value
Observable performance
Incentives
Verifiable performance
3rd party enforcement
3rd party, judicial enforcement
8
Compensation Function (3). Group or individual?

• Key issue relative advantage of specialized
  versus mutual performance evaluation
• Larger group size makes specialization relatively
  preferable
• Greater within-team interactions make mutual
  systems preferable

9
Compensation Function (4). Puzzles in variable
compensation

• Short term not predominant, even in the USbut
  long-term variability hard to estimate
• Asymmetric use of prizes and punishments wage
  reduction damages morale and is seen as unfair ?
  better to dismiss underperformers
• Use of ceilings to avoid aberrant effects?
  Aberrant results, exogenous risk, equality.
• Use of minimums despite causing reallocation
  (e.g., in sales, public works)as insurance?

10
Compensation function (5). Performance evaluation

• Objective evaluation
• Objective aberrations
• Contractual problems standards tricky to set and
  move
• Employees self-protect through social norms
  stipulating a certain effort
• Difficult to change ratchet effect with piece
  rate moving standards ? ? ?
• Factors technical change, trust
• Famous Lincoln Electric case Next

11
Working / Careers at Lincoln Electric(http//www.
lincolnelectric.com/corporate/career/openings.asp)

• Both entry-level and skilled positions require
  working a rotating shift on either a two or three
  shift basis. In addition, most plant operations
  positions pay on a piecework basis. That means
  pay is based directly on output.
• All of these positions offer excellent
  opportunities for quality-conscious,
  productivity-minded individuals who are
  interested in being rewarded for their excellent
  performance.
• Incentive Performance - A Cornerstone of Our
  Culture. The Incentive Performance System
  primarily attributed to James F. Lincoln has been
  in place at Lincoln Electric since the early
  twentieth century. It has resulted in one of the
  oldest "pay-for-performance" systems in the
  country, and is frequently used for benchmarking
  by other businesses and studied by academics
  around the world.
• The Incentive Performance System in place in the
  U.S. Lincoln operations features
• An elected Advisory Board for direct and open
  communication with senior management since 1914.
• Piecework incentive rewards for all production
  work.
• A profit-sharing Bonus Plan for employees paid
  annually at the discretion of the Board of
  Directors since 1934.
• Guaranteed Employment after three years of
  service. The company has not exercised its layoff
  options in the U.S. operations since post war
  1948.
• 401(k) plan offering the employee a variety of
  pre-tax investment options.
• Competitive compensation and other benefits.
• A Financial Security Program which includes
  company contributions based on years of service
  from 4 - 10.
• An attractive vacation package based on
  comparable years of service.

Through this well-defined group of incentives,
Lincoln encourages and compensates individual
initiative and responsibility. Employees work
together to reduce costs and improve quality.
These individual and cooperative efforts create a
more profitable company, the success of which
each person shares according to his or her own
contribution.
12
Compensation function (5). Performance evaluation

• Objective evaluation
• Subjective evaluation
• Corrects objective aberrations (Baker/Gibbons/Murp
  hy QJE 94)
• Requires relational contracting, 2nd party
  enforcement
• Causes subjective aberrations
• Systematic and unintentional failures ?
  Questionnaires
• Rent-seeking ( influence) activities
• Rejected by middle managers (b/c we value
  ourselves too bad / too good in absolute /
  relative terms) ? Important amounts
  expectations
• Frequency of evaluation
• Cost Measurement Rent seeking
• E.g., promotions in Japanese firms, entry in
  Civil Service
• Value before specific investments

13
Compensation function (6). Careers deferred
compensation

• Compensating labor in the long term
• Examples Seniority, non-vested pensions,
  pantoufles, audit firms partners, professions
  with entry barriers, etc.
• Long term ? investment ? expropriation risk if
  specific

14
Compensation function (7). Deferred
compensationMain issues

• Why?
• Performance unobservable in the short run (e.g.,
  quality, professionals)
• Also specific human capital (e.g., info
  required for coordination) employees risk
  aversion (?)
• How?
• Compensation through quasi-rents deferred
  compensation

15
Compensation function (7). Consequences of
deferred compensation

• Self selection of people with low discount rate ?
  more fraud-adverse? ? Lower expected turnover
• Stronger effort, if future compensation is not
  vested (threat of losing quasi-rents)
• What happens with professionals regulation?
• But quasi-rents can be expropriated ?
• ? Might be better to determine promotions and
  deferred compensation by seniority than by
  evaluating performance
• ? Vested compensation ? still self-selection, but
  not stronger effort e.g., Civil Service,
  promotions in Japan

16
Compensation function (8)How to contract careers

• Mandatory law
• Permanent employment dismissal triggers
  established indemnity ? 3rd party, judicial
  enforcement ? parties cannot opt out legally
• May trigger workers opportunism ?
• Less incentive for employers to contract ?
• More careful and personal selection, high capital
  intensity, unemployment,
• Enabling law
• Idem unless parties contract out, agreeing e.g.
  on termination at will
• Employer performs quasi-judicial function often
  with the help of workers boards (e.g., Japan,
  Lincoln Electric)

17
Compensation function (9)More issues on careers

• Mandatory retirement
• Japan 54 years for permanent employees
• Needed in final years b/c compensation gt
  disutility of work
• Promotions as a reward system
• Careful evaluation ? controls for long term
  performance
• Matching problem (Peters Principle) also
  appointment
• ? better when same abilities required in
  different ranks
• ? Otherwise, does not motivate technical,
  salespeople, etc.
• ? Two tracks needed
• More ?

18
Compensation function (10)Still more issues on
careers

• Tournaments
• Prizes fixed in advance, allocated through
  relative performance
• Spread between prizes is the motivating factor
• When luck is more important, more spread needed
  for same effort
• Advantages (MR, 384) Ordinal information, Prize
  pool set in advance
• Compensation of Stars
• Tenure Up or Out
• Common in consulting and professional firms and
  universities
• Explicit tenure helps recruiting good candidates
  current workers do not feel threatened
• (implicit tenure may result from the fact that
  matching improves with seniority. Institutional
  constraints very important in Europe (not in
  Japan)
• Up or out
• fresh ideas
• eliminates incentives to cheat by unfairly
  denying promotion difference of gaps needed to
  encourage employees to invest and employers to
  promote employees
• less costly for producers of non-specific human
  capital good outside Jobs

19
Managing our incentives