Employment Relationships Chapter 15 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly.

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Employment RelationshipsChapter 15

(c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.


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Introduction


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Big Blues

At IBM pay was competitive and employment was secure through the 1980s. A high

performing employee could count on an upward ascent

into management. After 1985, IBM’s fortunes fell. When Louis Gerstner came along in 1993, he became

the first CEO to upset other traditions—IBM would

finally see mass layoffs and division closings.


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What’s Next?

Employment relationships are as important as family ties for many of us, whether we are employees or employers. “Self-employed” just means there is no

boss between you andthe customer. Our study of employment will illustrate

how much light economics can shed on seemingly ordinary business relationships.


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MARKETS FOR LABOR


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Supply - Wages and Hours

Income is the opportunity cost of leisure time and vice versa—an extra hour of leisure comes at the price of an hour’s wages.

Thus, it takes theoffer of a higher wage to entice

people to work more hours. This gives rise to labor supply

curves like the one shown.


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Supply - Supply of Labor to the Market

Understanding the supply and demand for labor requires us to be quite clear about the exact market we are analyzing. The opportunity cost of supplying

labor depends on the worker’s alternatives. As a first approximation economists often assume

that workers are identical and model demand and supply conditions in Houston. For other problems

distinctions among skills are important.


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Supply - Human Capital and Long-run Supply

Productivity may be an accident of birth, like a unique musical talent, but most people must incur

costs to build up their earning powers. Your value to employers will depend in part on the skills you have

chosen to develop, which economists call investments in human capital. Investments in human

capital take place under uncertainty. A college education has general applicability but learning how

to operate a machine in a factory has much more specific applicability and therefore is a riskier

investment.


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Demand – The Employer’s Objectives

Marginal product is a measure of theextra output generated by adding

an additional unit of labor to a production process.


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When the marginalis multiplied by the

price that the productproduced by the

labor will fetch in themarket we get the value of marginal

product (VMP) shownat the right.

As long as VMP>W, a firm will hire additional units of labor.


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Labor’s VMP also rise with human

capital. A worker can acquire general human capital that increases productivity by

making investments such as formal education.

Productivity may also increase with experience

in a particular job. In general, increases in labor’s VMP will lead to an increase

in the demand for labor.


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Labor Market Equilibrium

Equilibrium in the labor marketoccurs where quantity suppliedequals quantity demanded. Inthis case, at a wage of $12 with50,000 units of labor employed.


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Labor Market Equilibrium

Shifts in demand and supply help in the analysis of many labor market phenomena at many possible

levels of detail:

• We could explain long-term trends in average wages and employment as a general rise in educational levels raises productivity, and thus both wages and employment.• As computers have made workers more

productive, the demand for them shifts upward and their wages and employment increase.


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What Supply and Demand Do Not Tell Us

So far so good, but there are many things about employment that supply–demand diagrams don’t help us to understand. Behind

supply and demand, however, we treated labor like a commodity that traded in spot markets. In particular:

1. We assumed that workers could easily learn about job vacancies and wages, and could move quickly and at low cost to push wages toward equilibrium.

2. We mentioned investments in human capital but did not explore their consequences.

3. We did not ask why long-term employment is common, even though markets and technologies change over the years in ways that could not have been foreseen when a relationship began.


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EMPLOYMENT AS A CONTRACT


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Information and Adjustment in Labor Markets

The assumptions underlying our basic supply–demand model are unlikely to hold completely in labor markets. Often, there are large numbers of

possible buyers and sellers, but neither people nor positions are standardized. Generally, we expect to see a range (distribution) of wages rather than a

unique equilibrium. By most measures labor markets adjust slowly to changes in supply or demand.


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Matches and Contracts

Labor markets are characterized by high information costs to both employers and employees. a labor market is a matching market, where the value a

relationship creates will depend heavily on how well employees and employers meet each others’

expectations. Either party can initiate the unmaking of a match, but only at a cost. Only a handful of

employment relationships are simple enough to be governed by written agreements. Professional sports

contracts or actors contracts are examples of such relationships.


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Incompleteness and Opportunism in Employment - Incompleteness

An employment relationship need not be memorialized in an enforceable contract, but even without one the parties become aware of

each other’s expectations and will likely attempt to meet them. Mutual expectations

give the employment relationship some aspects of one governed by a contract, but the need to accommodate change means that it must be a

highly incomplete one.


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Incompleteness and Opportunism in Employment - Efficiency Wages

Employment is a principal/agent relationship in which the worker (agent) receives assignments from the

employer or boss (principal). We now seek pay arrangements that can

induce ongoing effort by the employee. One possibility is for the employer to pay an efficiency wage that is

above the marketlevel.Where might we actually see efficiency

wages in operation? All else the same, they are more likely if monitoring is more costly.


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Incompleteness and Opportunism in Employment - Two-sided Opportunism

Both employers and employees can behave opportunistically.

A worker who understands the high costs of replacing him may choose a lower level of effort than one who is more easily replaceable. Employers who cannot be bound by enforceable contracts might do

likewise.


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LONG-TERM EMPLOYMENT


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Wages and Productivity - Lifetime PathsAll of the aforementioned difficulties in incomplete

contracting and opportunism might lead you to a mistaken

conclusion—that most employer–employee pairings

are of short duration. In reality, long-term

employment is common. This figure shows the

fundamental relationship that governs long-term

employment.


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Wages and Productivity - Characteristics of the Contract

So, why don’t wages match productivity over the worker’s years on the job, and why they exceed productivity only after some time has passed?

Backloading wages can induce greater effort from workers throughout the lifetime of their

employment relationship.


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Wages and Productivity - Employer Reputation and Enforcement

Why not fire the employee just before his wage would go above his productivity? An employer who

disappoints employee expectations in this way, however, can acquire

a reputation as untrustworthy, which would disadvantage it in the competition for workers. New

workers may be unwilling to start at low wages because they expect to be terminated early in their

careers.


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Internal Labor Markets - Classifying Jobs and Setting Pay

Promotions raise the question of why managements often restrict their searches to fill vacant positions to current employees, forgoing even a look at the many potential candidates outside the firm. A firm that limits its choices this way is said to utilize an internal labor market.

Job positions and descriptions of their responsibilities are a relatively recent development. Job classifications and pay based

on experience resolve some of the problems that come from team effort and allow management to avoid the difficult tasks of measuring and comparing the productivities of individual

workers, while also giving experienced workers the higher wages they expect under their unwritten long-term employment

contracts.


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Internal Labor Markets - Low-level Promotions

An internal labor market facilitates comparisons between candidates for a promotion. Unlike outside

applicants, their on-the-job conduct can be easily observed and their records are kept as part of ordinary

company business.


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Internal Labor Markets - Mid-level Promotions

Information may be harder to process for higher-level promotions than for lower-level ones. Moving upward, the information becomes harder to evaluate, and those

who choosethe winner may not be certain what weights to place on the different bits of information that are available. Part of the decision maker’s skill is in deciding which

of thatinformation to take seriously.


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Internal Labor Markets - High-level Vacancies

Now assume that there is a vacancy in a position such as chief

executive officer or chief financial officer. The board of directors’ decision to use the internal labor

market may not be a sound one, particularly if the vacancy arose because the lastholder of the position was fired.


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PAY AND INCENTIVES


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Designing Compensation Plans – Piece RatesThe apparel industry includes many small firms that

assemble garments from pre-cut pieces of fabric. Piece

rates are relatively rare in the economy, and their existence in this industry reflects certain

characteristics of the assembly job and the work environment:

1. It is easy to count the number of garments a worker completes and check their quality.

2. The job does not involve team production.3. The worker’s output is within her control and

is little influenced by random events.


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Designing Compensation Plans - Hourly Pay

Team production makes an individual worker’s productivity hard to observe because extra effort by a

single worker will usually have little effect on the team’s output. Workers

on teams may have little choice about their effort levels, for example, if they are on an assembly line

whose speed sets the pace for all of the workers. In cases like this we would expect to see the pay of a

team’s members depend on the actualhours the group is present in the workplace, as

opposed to piecework pay that allows random events to determine a member’s income.


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Designing Compensation Plans - Fixed Salaries

Supervisors are often on salaries that pay a fixed amount each month, independent of the hours they

work. In part the difference is due to observability. It is harder to enumerate a supervisor’s responsibilities

and measure his efforts. Simply being a supervisor usually indicates that a person is on a long-term

career path, and he will be motivated to make effort today for bonuses, promotions, and higher pay that he

may not receive for some time to come.


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Designing Compensation Plans - Shares and Commissions

The contingency-fee arrangement for paying the plaintiff’s

lawyer in Chapter 10 exemplifies a common payment mechanism called a share contract. Salespeople on

commission operate under share contracts, and sharecropping is a common

mode of farming around the world.


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Designing Compensation Plans - Tips

Restaurant servers, taxicab drivers, bartenders, and a few others earn much of their incomes in the form of tips or gratuities from customers they serve. Tips

resolve acombination of monitoring and incentive problems.

Tipping rewards the conscientious server for activities that increase the restaurant’s goodwill but

are likely to go unseen by the owner.

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Designing Compensation Plans - Executive Compensation


Performance-related pay can reward improvements in such measures of company performance as earnings

relative to its own past or relative to others in its industry. Measures

of performance should be within the control of executives, however. A performance measure should also be resistant to manipulation by the people being

rewarded for it.Common alternatives to performance-based pay (sometimes used alongside it) are based on the market

performance of the company’s stock.

Employment Relationships Chapter 15 1 (c) 2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly.

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