Chapter Eleven
Personnel and Compensation
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Principal-Agent Issue
• Employer -- Employee
• Customer -- Supplier
• Manager -- Subordinate
• CEO -- Middle managers
• CEO -- Board of directors
• Shareholders -- Board of directors
• Shareholders -- CEO
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Principal-Agent Issue
• What we might call the “Internal Labor Market” is what goes on between managers and employees inside a firm.
• How, for instance, can the managers ensure their employees are the best out there?
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The Internal Labor Market
• Efficiency wages:• Pay more than opportunity costs.
• What would this do for the employee?
• Two things:• It would make employees not want to shirk and get
fired and
• They would be attracted to the firm only if they were indeed the best and could meet expectations.
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The Internal Labor Market
• Compensation profile: a comparison of compensation and productivity or value to the firm.
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Pay
Years with Firm
What if the compensation pattern over time looked like this?
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The Internal Labor Market
• Why would compensation rise over time?• Perhaps because employees become
more valuable to the firm, that is, they become more productive.
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Pay
Years with Firm
Actually, in most cases, compensation and productivity are different.
compensation
Compensation/Productivity Profile
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Pay
Years with Firm
compensation
Compensation/Productivity Profile
Here, compensation is greater than productivity in later years and less in earlier years
productivity
• This type of relationship between compensation and productivity is called backloaded compensation.
• What would it mean for an employee to face a backloaded compensation scheme?
• The employee would want to remain with the firm for many years
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Backloaded Compensation
• What would downsizing mean if compensation is backloaded?• It would send a signal to employees that
they might not ever capture their backloaded wages – this could lead to lower quality employees.
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Other Internal Market Characteristics
• There are efficiency or economic reasons for everything you observe working in a firm. For instance, can you explain:• What is the purpose of a bonus?
• What would you tie a bonus to?
• What is the purpose of a promotion?
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CEO Compensation
• For Fortune 500 companies, the average CEO makes 200 times more than the lowest paid employee
• Many say this is excessive.
• Is it?
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CEO Compensation
• Issues to consider:• Incentives.
• Are managers (CEOs) exempt from performance pressures?
• What can be done if a manager is not performing well----not increasing shareholder value, that is?
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CEO Compensation
• Issues to consider:• Perhaps the board of directors can fire the CEO.
• What is board of director’s objective?
• Perhaps the firm can be taken over and the CEO fired.
• What about golden parachutes, greenmail, or poison pills? Are these efficient or inefficient – explain.
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CEO Compensation
• What is the role of stock options?
• How do they tie CEO compensation to the performance of the firm?
• How did the use of options go so wrong in the early 2000s?
• The problem was that the link between CEO compensation and firm performance was at best very weak.
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Another Issue in the Internal Labor Market Is the Architecture of the Firm
• Piece Rate Compensation:
• An individual is paid according to the amount the individual produces.
• A great example is Lincoln Electric.
• When would piece rate compensation not be efficient?
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Another Issue in the Internal Labor Market Is the Architecture of the Firm
• “Teams are the only way to be successful.”
• “When people work together, the team spirit spurs individual effort.”
• What is the situation with teams? What are the incentives of individuals in a team?
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When would teams work and when not?
• When production is easily tied to individual productivity?
• When the productivity of the individual is costly to measure?
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Subjective Evaluations
• This occurs when a superior evaluates someone but the evaluation is not quantitative but more “touchy-feely” or opinionated.
• Why would subjective evaluations be efficient?
• To increase cooperation among employees or to create an incentive for behaving in a way that benefits the firm that is not easily measured.
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Risk
• What happens when an employee’s compensation is based on factors that are not in the control of the employee?
• There are no incentives to perform.
• Thus, in circumstances when some of the employee’s compensation is tied to factors beyond the employee’s control, we say the employee is subject to risk (non-diversifiable risk).
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Risk
• The efficient compensation scheme must reduce the negative incentive effects that occur from risk.
• The firm must share the risk with the individual.
• This is one reason that compensation is based on individual performance, team performance, firm performance, and subjective evaluations rather than just on one of these factors.