Managerial Economics/Personnel Economics
"Personnel economics" is the acquisition and management of human capital. The competition to capture talented employees in fast-growing industries is fierce. Successful firms, therefore, are often those who are able to attract, hire and retain important skilled employees. Personnel economics highlights the fundamental ideologies and frameworks involved in hiring, retaining and motivating employees.
Personnel economics is a relatively new discipline, emerging within the last several decades. In this time it has drastically altered business operation from a human resources perspective, allowing for improvements to recruitment, retention and compensation. As a result, in today's corporate landscape, HR practices vary wildly from business to business, with activities primarily designed to create the best fit with an organisation's strategy.
Personnel Economics versus Human Resource Management
Personnel Economics analyses how an organisation can utilise economic theory when deciding upon Human Resource strategies. Specifically, it applies modern econometric and statistical problem-solving methods to traditional Human Resource problems such as compensation, teamwork and hiring. This mathematical approach distinguishes Personnel Economics from organizational behavior and strategic human resource management approaches. It also focuses only on labour markets within a firm, and so is distinctly separate to Labour Economics.
Why do people choose to be employed[edit | edit source]
1. Cost of Living - a desire or need to sustain a predetermined standard of living by affording for basic living necessities like food or health, can be conformed to the price to live. Generally, bound to wage rate.
2. Desire - to feel contentment from the completion of tasks or achieving goals & to receive admiration of others and to hold authority.
4. Identity - if you have an inheritance you do not need to work however you may choose to continue working to feel a sense of belonging.
5. Social aspect - instead of staying home all day and living off your inheritance. It is also a norm in society to have a job and work, so by not working the individual may feel unusual.
What can managers do to motivate and retain employees?[edit | edit source]
Empirical studies have proven that there is is a strong and positive association between employee’s motivation and organizational performance (Aftab Tariq Dar et al., 2014). Therefore, it is crucial for a company to keep employees motivated. Many managers generate motivation among employees through the implementation of diverse methods in which they create an enjoyable work environment.
The practice to retain and motivate employees can be time-consuming and an expensive proposition. There are, however, procedures/ options that managers may implement.
High achieving employees want to be challenged to prove their self-worth and skill set. This is integral to the development of individuals and, subsequently, their career growth. This inherently generates a feeling of belonging as employees may feel the contentment from being personally mentored by their manager. Creating challenges allows employees an opportunity to try something they haven't or develop on skills they already possess. Because of the rising expectation, their level of performance (and job satisfaction) will also increase.
Pay must be in line with the industry standard to avoid employees transferring to more attractive contracts with competitors. Giving incentives such as commissions through monetary payments may assist with the productivity of employees and help with workplace culture.
Employees must be able to make their own decisions and be held accountable for them. Micro-managing of employees may lead to low employee morale, high staff turnover and reduction in productivity. Allowing employees to make their own decisions will assist them with growth and innovation. Grooming leaders and not just sheep following instructions.
It is necessary to remove the employees who do not perform and are disruptive in the workplace. Hostile work environments create large employee turnover. In with the good and out with the bad.
Award members of the organisation that are overachieving and taking the initiative by introducing performance-based pay. Although, non-monetary rewards are also effective, e.g., praise, recognition and growth opportunities, etc.
Acknowledge Employee Achievements
Constructive criticism may help us learn from past mistakes, but recognising a job well done is what encourages employees to raise their performance bar, as offering praise for good work helps employees feel valued for their contributions.
Make the Work Environment Enjoyable
If a companies workplace environment is more fun and aesthetically pleasing, up to date with the latest technology and clean the employees will feel much more comfortable and maybe more productive at their place of work.
Direction for Growth
A manager should show employees the direction in which they are most likely to grow. If the company is expanding at a fast rate, frequently giving current employees chances to grow within the business is a key motivator for employees.
Employee benefits such as lunch being offered a few times a week or month. Or perhaps a free gym or yoga class twice a week in the nearby gym. These are all examples of benefits which help keep employees feeling valued and keeps them motivated to perform at their highest potential.
Environmental Transformational Leadership
Environmental transformational leadership facilitate the employee’s autonomous motivation. It also seems to be linked to increases in the employee’s external motivation. 
Good coworker relations exert a positive impact on employee motivation and employee intent to stay. Furthermore,as more organizations rely on effective teamwork for their success, good coworker relationships will become increasingly important.
Principal-Agent Framework and Incentives[edit | edit source]
The Principal-Agent Framework is the relationship between an employer (principal) and an employee (agent). Principals rely on agents to act in their best interest and maximise the utility or outcomes of the principal. This underpins the relationship between the two, however, in practice misaligned incentives can cause a conflict of interest, which arises when an agent has differing goals to the principal. Conflict can cause an averse selection of an employee (uncertainty in hiring choice) leading to an inefficient choice, and/or a moral hazard (uncertainty in the method of motivation for the employee) in which an asymmetry occurs in Agents possessing better information than Principals. There are two approaches to resolving this conflict of interest.
Methods of resolving incentive conflict[edit | edit source]
- Fixed payment WITH monitoring
- Where agents are provided with a fixed salary, and their performance is monitored.
- The limitations to this are:
- Shirking: A variety of the free-rider problem; because agents are already being paid, there is no incentive to act in the best interest of the firm.
- Monitoring Costs: Monitoring and measuring agent performance require additional resources and labour the firm will have to account for.
- Adverse Selection: Agents who want to shirk will look for jobs where output is not closely monitored.
- Incentive pay WITHOUT monitoring
- Where payment is correlated with the output produced by the agent, and their performance is not monitored.
- The limitations to this are
- Inequitable Pay: Delays and interruptions can sometimes be random and unavoidable, and it would be unreasonable to punish agents for these discrepancies.
- Compensation: As agents are bearing risk with payment, employers may be required to provide them with a risk premium.
Corporate Social Responsibility Theory[edit | edit source]
Numerous private firms attempt, or at least try to appear, to be socially responsible, through charity contributions or voluntary commitment to ethical and moralistic principles. Primarily these acts were driven by two main concepts. Firstly, that such moralistic behaviour may produce greater profits as consumers are willing to pay more for ‘responsibly’ sourced products. Secondly, in response to the possible introduction of regulations or new taxes. However, recent economic models (Frank 2003) suggests that worker motivation is heavily influenced by the apparent ethics of the company. The main concern to building on social responsibility is the idea of over investing and incurring extra costs. These extra costs eventually leading to weakening profit and potentially being pushed out of the market by less responsible competitors.
Social Responsibility theory suggests that by using corporate social responsibility and without public intervention the firm actively promotes social and moralistic goals, i.e. refusing to use child labour, it could act as a screen against moral hazard and attract more productive workers (Brekke, Nyborg 2004). This is in contrast to contemporary economics that suggests cutting production costs leads to further profitability. However, the empirical findings indicate that many employees prefer social responsibility and may actually pay a large premium, likely in the form of a reduced wage relative to other similar firms, to help the firm (Frank 2003). Furthermore, it was found that firms considered less socially responsible had to pay significantly higher wages. On average, for profit firms payed 59% in wages more compared to non-profit ones (Frank 2003). This theory contends that firms could exploit the correlation between social values to attract productive workers, thus reducing the issue of shirking, and also allow relatively lower wages (Brekke, Nyborg 2004).
Recent studies indicate that positive social responsibility highly correlates with attractive employee traits. Workers show more initiative, contribute and exert more effort and shirk far less. While these traits have been demonstrated across a significant number of individuals interested in responsible firms, it's impossible to accurately observe whether or not someone is a ‘co-operative type’ prior to employment.
In all markets high and low social responsibility firms exist and compete. The corporate social responsibility theory suggests that its possible for these low responsibility firms to be driven out of the market. Even if a significant portion of potential employees had little or no motivation to work, corporate social responsibility screening may drive out competing firms with a weak social responsibility profile. A high social responsibility attracts ethical and motivated workers, who are willing to work for lower wages, that can outperform their less motivated counterparts from low responsibility firms. Frank (2003) conducted a hypothetical test to determine the desired wage and preferred positions between two jobs, Camel cigarettes and as an ad copywriter for the American Cancer Society. He found overwhelmingly that 88% of people preferred to work for the lower paid and less prestigious position at the Cancer Society rather than at Camel Cigarettes. However, other reports suggest that the required wage compensation necessary to make employees prefer the low responsibility firm may not need to be high.
The Trust Game[edit | edit source]
Created in 1995, the (Trust Game) is an experiment to test and measure trust in economic decisions. The intended result is to show that trust is equally as inherent to economic transactions as self-interest.
The game is executed between two players. An amount of money, x, is given to Player 1. Player 1 is then told that he must give an amount of money to the second player (which can be anywhere between 0 - x). The amount Player 1 sends is then multiplied (the value of which is at the discretion of the experimenter) and given to Player 2. Player 2 is then required to give some amount of money back to Player 1 (anywhere between 0 - 3x).
Traditional economic theory assumes that by being a rational, self-interested individual, Player 1 will choose to send nothing to Player 2. In practice, however, it is shown that Player 1 will typically send close to 50% of their initial endowment. The money sent in response by Player 2 is reported to vary depending on the level of information provided to Player 2 about Player 1. Nonetheless, Player 2 on average sent back an amount that was in excess of their payment from Player 1. These results show that the behaviour from Player 1 and Player 2 are substantially different from predicted behaviour under the assumptions of traditional economic theory.
Another question posed under the Trust Game is: can explicit punishment affect cooperation? Under a one-shot, anonymous trust game, two treatments are imposed:
- Trust condition, no punishment (that is, Player 1 places trust in Player 2 that they will return a "fair" portion of the money).
- Incentive condition:
* Player 1 specifies a desired back-transfer, y, from Player 2 * Player 2 can be issued a $4 fine by Player 1 if they send less than y back.
The game can then end in three equilibriums: incentive condition (fine not imposed), incentive condition (fine imposed), and trust condition (fine not eligible).
- Higher levels of back-transfer when the incentive condition is in operation but there is no fine imposed.
- Combining the incentive condition with the imposed fine produces the smallest back-transfer from Player 2.
Gift-Exchange Theory[edit | edit source]
Gift exchange (or fair wage) theory states that for the worker's side, the gift that is given is the work that pays price P, where P > minimum standard; and for the firm's side, the gift that is given is paying the excess of what the workers may gain if they work elsewhere.
Gift-Exchange Experiments[edit | edit source]
According to Fehr et al. (1993), laboratory experiments support the gift exchange theory.
- When the supply of labour in the market is in excess, workers have no incentive to be more productive given the minimum pay rate. Hence, employees do not exert much effort to improve the quality of the work they produce.
- Given that employees invest only minimum effort to produce quality work, then employers have no incentive to increase worker's wages above market-clearing level.
In contrast to the predicted gift exchange experiments conducted by Fehr et al. (1993), most employers offer employees a higher pay than market-clearing wages. At times, employers offer more than 100%.
- On average, employees reciprocate high paying job (or simply high wage) by exerting more effort, making it profitable for companies (or employers) to provide high wage contracts. Other laboratory experiments also showed similar results.
- Although initially employees work harder, positive reciprocity does not last in the long run according to Gneezy and List (2006). However, with other field experiments conducted by Kube, Marechal and Puppe (2008), they found that there is a lasting relationship between incentives and worker's productivity.
Hidden Costs of Control (Falk and Kosfeld, 2006)[edit | edit source]
There are consequences (or hidden costs) associated when principal (employers) try to control the agent (employees). An employer's distrust in the performance of its employees can negatively impact his/her motivation to work. Most agents who react negatively say that they perceive the controlling decision as a signal of distrust and a limitation of their choice autonomy. Control entails hidden costs resulting in reduction of employee's performance as a result of the controlling decision of the employer.
It's possible that managers can increase the minimum monitoring to much higher levels. This might be worthwhile, but in practice, it also induces substantial costs to the business.
Empirical evidence suggests that when trust levels are high between superiors and subordinates, on average, there is a higher return in performance, which translates to a higher payoff. When there are lower levels of trust between superiors and subordinates it can result in lower performance of their subordinates due to the limitation set by the superiors.
The majority of the principals seem to anticipate the hidden costs of control and decide not to control.
This theory coincides with the gift exchange theory as in a sense employee are afforded a ‘gift’ in reduced monitoring which improve morale, as workers feel appreciated, thereby instilling a desire to reciprocate by giving greater effort. It should be noted, however, that several experiments dispute the long-term effectiveness of the gift exchange theory as they found that positive reciprocity depreciates over time.
Pay for performance[edit | edit source]
It is common amongst some companies to pay a fixed salary, while others pay based on performance. A performance orientated structure may be successfully implemented if mangers are capable of measuring both quantitative and qualitative employee results. If implemented successfully, benefits include:
- Improved work rate as employees are incentivised to succeed
- Attracts highly performing, motivated and driven workers
- Increased flexibility as employees are judged on results that they bring to the table rather than subjective measurements
- Attracts highly productive workers as productive workers' performance are accountable for the amount of wage they get, they will feel better as they have more control over their wage rate instead of a fixed rate.
- Better retention because high-achieving performers will be satisfied by the working environment and their income based on how much efforts they paid. Apart from it, they can earn reputation and respect in the work organization if they have huge contribution to the company.
- unlimited compensation because pay-per performance may allow the employee to earn a substantial income. Because of the more effort they paid, they may earn more money, it can allow talented-salesperson who receive a fixed salary to be paid based on the volume of sales, which can allow them to receive income far more than the fixed salary.
Performance orientated structures become problematic when current results do not reflect the future repercussions. For example, it is common for salaries of CEO's to be paid in stock options which are only redeemable at a future date. This ensures CEO’s and leaders have an ongoing incentive to do well over long periods of time, subsequently, it also makes sure to align the CEO's interest with the companies so as to ensure that the price of stock does not decrease over time. Therefore, eliminating short term decisions which may have negative future consequences or repercussions. It is difficult to link the payment to future performance, challenges include:
- Costs associated with actually quantifying performance
- Difficult to quantify
- Even if the output is quantifiable, the observability might not occur when it is needed (e.g. it might take up to 5 to 10 years to see the specific output). As a result, the payment cannot be linked to the performance timely
- Lack of teamwork which can create hostility as this structure often generates the notion of every man for themselves.
- Increased competition for highly skilled workers: skilled workers will be a lot more mobile looking for pay-for-performance jobs as structures based off of incentivising performance rarely develop a culture of loyalty or sense of belonging.
Research shows compensation for employees has shifted towards pay-for-performance. The Journal of Economic Perspectives published an article in 2007 ((Lazear and Shaw, 2007) show that the share of large firms that have more than 20% of their workforce individually incentivised had grown from 38% to 67%. Meanwhile, the share of firms using group-based incentives had grown from 26% to 53% (Lazear and Shaw, 2007). Group incentives may leverage the benefits of pay-for-performance while still increasing teamwork.
Power laws in Economics: CEO pay[edit | edit source]
The talent of the chief executive officer (CEO) is based on how much he/she can raise the revenue (in %) of a firm. Competition arises when firms compete to hire the best CEO. Although this tighten the competition between CEOs, this process produces an efficient outcome for firms. CEOs are ranked and paid based on their productivity and basic ability to heightened the revenue generated. Hence, the best CEO in the economy will be matched with the largest firm and the second best will be matched with the second largest firm and so on and so forth.
CEOs are paid using the equation below:
- S(n) is the size of the firm that the CEO manages
- S(n*) is the size of the reference firm (median firm size in the industry)
- D(n*) depends on model parameters like the scarcity of talent
- b ranges from 0.3 to 0.4 (suppose b=1/3)
Model Implications: double power law (scaling in both average firm size and own firm size):
- Cross-sectional prediction: The compensation of a CEO is proportional to the size of the firm to the power of 1/3, S(n)1/3 (e.g. if a firm grows 8 times bigger, the CEO of that firm earns twice (81/3=2) as much as before)
- Time-series prediction: When the size of all large firms is multiplied by λ, the compensation at all large firms is multiplied by λ (e.g. if all firms grow 8 times bigger, the pay of all CEOs is 8 times more)
So the trend of CEO's being overpaid might be just due to market competition and the growth of the economy.
Economics of Superstars[edit | edit source]
The phenomenon of Superstars, where in relatively small numbers of people earn enormous amounts of money and dominate the activities in which they engage. Power economics implies that a small difference in talent gives rise to very large differences in pay. Differences in talent are small and bounded, but gains are large and unbounded. For example, when very large firms compete to hire the services of a CEO, small differences in talent give rise to large differences in pay. With so much more at stake, it has become that much more important for companies to put at the helm the “best” executive or banker or fund manager they can find. This is also the same in other markets with superstars such as athletes and artists, for example football player David Beckham. In 2009, he became the highest-earning football player and made $33 million from endorsements on top of a $7 million salary from the Los Angeles Galaxy and AC Milan.
Case Study: Superstar salaries in the NBA[edit | edit source]
A perfect illustration of power laws and superstar economics are the salaries of professional basketball players in the National Basketball Association (NBA). According to the National Association for Sport and Physical Education, only approximately 0.02% of high-school basketball players in the United States end up playing professional basketball in the NBA. The league consists of 30 teams with 12 contracted players on each roster, leading to a total of 360 players in the NBA. The difference in talent between the 360th (worst) player and the 1st (best) player is minuscule when considering the fact that all NBA players are in the 99.98th percentile of basketball players in the United States. However, as of 2019, the minimum salary (for theoretically the worst player) is $898,000/year while the maximum salary (for theoretically the best player) is $40.2 million/year. The best player in the league is not 45 times better than the worst player in the league. The difference in salaries is a product of the exponential revenue gains from having a 'superstar' level player on the team.
According to experts from the Massachusetts Institute of Technology's Sloan School of Management, having just one 'superstar' player on an NBA team can increase franchise revenue by up to 25% annually. This drastic increase is due to a myriad of factors, including increased ticket prices (as customers are willing to pay more to see a superstar), increased team performance and more marketing opportunities/brand recognition. When all the benefits of signing a superstar player are taken into consideration, it becomes apparent as to why relatively tiny differences in talent lead to massive differences in wages.
Unintended consequences of ‘pay for performance’[edit | edit source]
Unintended Consequences of Pay for Performance
Despite the apparent alignment between agent and principal incentives, the specific mechanisms of Pay for Performance schemes can result in various negative unintended outcomes. These usually arise due to:
- A misalignment of incentives and intrinsic motivations between the principal and agent;
- The difficulty of measuring ‘real’ talent and contribution of employees; and
- Structure of incentives which prefer short term results over longevity.
This can give rise to the following unintended consequences:
- Shift of effort from long-term goals to short term gains. For example, an employee may make decision to increase their salary over the next few months rather than decisions that will benefit the company in 5 or 10 years. Be it that the decisions might have detrimental consequences on the company in the long run, the employee will still decide to go with the short term gain as they value today more than the future.
- Incentivising easily measurable task such as short term goals of monthly KPIs may affect the long term goals of a firm which are less measurable. This generates a sequence of events that may roll out negative consequences with high inertia targeting the future of the company.
- Extrinsic incentives can crowd-out intrinsic motivation.
- Competition among employees can become detrimental to the overall team structure by causing a breakdown in group dynamics. This may manifest through sabotage (a worker "stealing" a client or a project of a colleague because it will be profitable/successful) and poor work ethic (every man for himself).
- Inequitable pay. Variation in the output produced by an agent may be caused by random circumstances external to the agent's control.
- Negative externalities arise when a firm changes its performance-based pay, this causes competitors to change their performance-based pay to incentivise and retain "talents", distorting their incentive structure and reducing the total surplus of the workforce
Tournament Theory[edit | edit source]
Tournament theory is proposed by Lazear and Rosen. Tournament theory holds that the salary increase associated with a given promotion will affect the motivation of employees below the job level; As long as the outcome of the promotion is not clear, employees are motivated to work hard for it. This theory assumes a relative promotion-gain system in which individuals are judged not on overall performance but rather on the basis of relative performance amongst fellow individuals in the organisation. Therefore, tournament theory operates on the premise that it will not motivate employees operating at the level of promotion in question, but rather incentivize individuals working below this level to compete with one another to strive towards promotion. Inturn generating a desired quality and quantity of output for the organisation. The theory of championship is put forward based on the fact that the salary level of employees jumps step by step with the promotion of positions. Other theories can not explain this fact. For example, neither career motivation theory nor human capital theory implies discrete salary changes, unless the learning process is discontinuous. The theory of human capital, literally, is a smooth increase in wages.
Similarly, there is no reason why pay should not be paid in the theory of career incentives (except on retirement dates).To explain the discrete jump of wage level, it is necessary to resort to championship theory and other explanations (for example, Rosen,1986). Many researchers have discussed or tested the championship theory, such as Bull, Schotter and Weight(1987). Ehrenbreg and Bognanno (1990); Knoeber and Walter(1994) et al.More famous is McCue (1996), who tested the championship theory with the income dynamic tracking study and found that promotion is very important in explaining the salary increase.McCue's research is instructive, but it comes from examining workers at different firms. Lazear (1999) supplemented her method by examining the salary data of all employees (including CEO) of a given enterprise (a large financial services company) from 1986 to 1994, and the results he obtained supported his theory.
How do workers compete with one another?[edit | edit source]
Approached in multiple ways, competing workers are present in a variety of scenarios. For example, workers can be seen competing with one another on a multi-divisional level (across different divisions within the organisation), across different branches (geographical disparity), or in close quarters. Therefore, the theory assumes all workers decide on their effort/ output simultaneously, with limited knowledge of their competitor's decisions. The main takeaway here is that effort levels are identified by employers and equilibrium in terms of effort can be established in order to achieve the desired amount of effort/ output based on the manipulation of the size of the prize (e.g. level of compensation for promotion).
Additionally, competition between employees arises as one of the unintended consequences of pay for performance. leading to cases like sabotaging or undermining another coworkers' effort or work. As this structure teaches the employee that there is a bell curve towards their performance index. For them to perform well, someone else must be performing poorly. Signifying that an employee will do whatever they have to to try and get the extra wage cut or to get noticed by the organisation to gain an edge in a promotion.
Why do employees get a pay rise when they get a promotion?[edit | edit source]
- Not because the job is harder but rather they are working more productively, raising their efficiency to a level that the general employee did not attain.
- Higher pay is a reward for being more productive (higher efficiency rating)
In brief, salary is based on the ranking of the marginal output of the agent, rather than the specific marginal output. The order of the marginal output is simpler than the accurate measurement of the marginal output, thus reducing the monitoring cost. Secondly, the tournament theory notions that there isn't a close relationship between executive compensation and organisational performance. This is due to the decision to make executive team compensation based on non-performance factors. Emphasis on compensation is included to induce executives to increase their self-effort. However, the theoretical model of the tournament suggests that the pay gap within the company has an impact on organisational performance. Thirdly, the theoretical model of the tournament assumes that when the external environment of the enterprise is highly uncertain, the marginal cost invested by the internal competitors will increase as the degree of uncertainty increases. In other HR practices, firms reward seniority instead of performance, giving pay raises with promotion to loyal employees. However, this is determined by the theme of HR practices being adopted at the firm.
Team Production[edit | edit source]
- Why do we use teams when it leads to the free-rider problem?
The "free-rider problem" refers specifically to group members taking a step back from the intended workload and letting the other members of the team to sacrifice more of their individual time and effort to fulfil the project and then ridding off their success. Teams are used throughout all forms of schooling life. Whether it be Primary school, High school, or University, generally to eradicate the importance that individualism does not always lead to success. Executing teamwork for the first time may cause students to be encompassed by numerous cultural shocks. These cultural shocks arising upon the beliefs that individual work won't be rewarded; instead the teams' performance overall will be assessed. Once these students are employed as post-graduates, many tasks are undertaken as a team. This is due to each person in the team acquiring different skills and knowledge. Furthermore, being able to distribute the workload over multiple people attracts precise and focused results. There are numerous ways in which the free-rider problem can be eliminated. A key resolution in the eradication of free-riding in teams is to organise set protocol when the team is initially chosen. By doing this, the importance of communication and undertaking decisions are developed. At this stage, the responsibilities and requirements of each team member are determined and agreed upon. Even though free-riding is a key issue, teamwork is issued because:
- Many projects require multiple skills that single individuals don’t possess. If there are complementary skills between group members, the team is able to capitalise off each individual's skill set. Often, this makes teamwork more productive than just utilising one person's skills. When workers' inputs interact multiplicatively so that each worker's marginal product is enhanced by combining effort with another worker who has different skills.
- Teamwork allows for different perspectives due to the diverse background of the team; this raises the quality of work being produced.
- If generalists are more expensive because their skills are scarce and difficult to obtain, then a firm will choose to use a team.
- In rapid changes in technology, it can make it different for one person to have an absolute advantage in everything.
- Teamwork requires communication, which can involve both common jargon and personal knowledge of each other.
- Psychological safety is crucial for effective communication
Pay Compression[edit | edit source]
In the last three decades variance of pay across workers has risen:
- Within and across occupations, within and across firms.
- Mainly because the upper tail of high earners has grown.
- Due to shifts towards pay-for-performance and growth in firm sizes.
Unequal pay can demoralise workers who are paid less than the coworkers who are “just like them”. This can lead to lower productivity, reduced agency as their performance is not being valued and thus low mental health also becomes an issue. People value equity or fairness from the organisation in wage rate.
Compressing pay (relative to output);
- can increase morale and worker efficiency (esp. in teams)
- but might lead to high productivity workers choosing to leave the firm for a higher pay wage in a competitor firm.
Individuals value fairness or equity from the organisation in wage rate and the degree of pay compression can be an efficient market outcome, for instance, a greater degree of fairness or equity produces higher productivity and efficiency ratings. Pay compression will vary across firms, in other words, firms who display a large amount of team-based work will have their pay compressed because an individual's output that would entice an outside wage offer may be more complex and difficult to distinguish from group results. Moreover, equity is more relevant in close comparisons.
Employees may define themselves by making their competitors look worse off (worsening others) or by making themselves look better than their rivals (bettering themselves). Cooperation is discouraged and employees try to outperform their competition, especially when pay or other forms of reward is in compliance with their performance. In order to deter this kind of behaviour against employees and their peers, pay compression becomes an integral part of their contracts. By incorporating pay compression, employees are less inclined to conduct any non-cooperative behaviour such as sabotage that might be induced by prisoner’s dilemma style payoff structure. Pay compression also mitigates any ideas where workers try to influence and lobby their superior by trying to appear better than another employee in the firm. (Shaw, 2007) 
Hedonic Model of Compensation[edit | edit source]
Employees care about more than just pay, such as flexible hours of work, comfortable working conditions, colleagues whom they enjoy, projects on which they enjoy working and bosses who provide recognition and mentoring. The employees also favour non-wage benefits, such examples include health insurance, pensions and superannuation funds. These benefits are preferred over a typical wage increase, but generally are dependent on the ages of employees – older workers are more likely to care about pensions and greater health insurance coverage compared to their younger counterparts.
The Hedonic model of compensation provides a structure for firms to use as an aide in answering these questions;
- Should the firm offer more pensions, or more health insurance, or flexible hours?
- How do benefits affect the amount of base pay offered?
Obviously, these benefits can become costly to a firm, especially in the cases of pensions and health insurance, not only that but flexible work arrangements can also increase the coordination costs for the organisation. These benefits also have productivity enhancing effects. However, the hedonic model focuses on the cost aspect of these benefits, i.e. assuming that productivity enhancement from these benefits do not necessarily outweigh the costs.
In order to combat this, the Hedonic Model of Compensation believes that a firm should offer the package of pay and benefits that will attract the workers that it desires; offer a younger employee less health cover but larger pay or offer an elder worker less base pay but more health insurance and pensions.
Human resource practices[edit | edit source]
Organisations now have a toolkit from which they can attract, retain and cultivate talent within the business. HR activities can be separated into two specific categories: skill-enhancing and motivation-enhancing. Skill enhancing practices allow for existing employees to grow within the organisation and vastly increase their contributions. Some examples of skill-enhancing practices include:
- Staff development training (external, sponsored MBA, etc) vs peer training vs mentoring (informal/formal programs for seniors/juniors) vs self-development
- Hiring for talent vs for experience (or can be a combination)
- Promoting diversity vs focusing on 'merit'.
In more detail:
- Staff development programs - these programs can vary greatly from organisations to organisations, with staff training taking the form of peer-to-peer training, mentoring programs, self-development programs through online modules and whatnot, even a buddy system for new employees or interns.
- Hiring for talent match rather than similar work experiences - work experience might not necessarily be a benefit to the organisation, besides the possible reduction in training time if said experience comes from a specific field. This is why companies nowadays look for talent, or rather qualities that they find align with the business' core values and operating methods.
- Promoting a culture of diversity rather than focus on hiring employees on a merit basis - diversity can bring a wide variety of perspectives to an organisation, encouraging innovation and growth in the long run. Promoting gender and racial representation in the organisation will lead to improvements in productivity and a reduction in marketing biases within the firm as new view points are introduced and accommodated for. Other companies may focus purely on 'merit' if it aligns with their company strategy. However, this could result in a non-representational workforce which is beneficial in other ways.
Organisations can also engage in motivation-enhancing HR practices, which can greatly increase productivity and employee retention:
- Performance pay vs fixed pay
- Close supervision (micromanaging) vs freedom and trust in employees
- Reward seniority (the longer you stay at firm the more you earn) vs reward (comparative) performance
- Job security (tenure; sometimes can't be fired even if performance is low) vs competitive selection (Darwinian approach)
- Intrinisic motivation vs extrinsic rewards (pay, etc.)
- Benefits and entitlements (types of leave, flexible working payments, high super contributions, etc) vs additional pay
In more detail:
- Performance pay vs. fixed pay - performance pay can provide a better extrinsic motivation than fixed pay grades, as they give an incentive to perform better and also prevents a "take the cheque and go home" mentality. Fixed pay is explained by the gift-exchange theory, where the reward for employees' wages in exchange, the gift the firm receives is the work produced.
- Close supervision vs. freedom and trust - close supervision might be necessary for organisations whose primary practices are complex and in need of peer review, but cultivating an atmosphere of trust enhances company morale. Freedom and trust can be complementary to the gift-exchange theory.
- Reward seniority vs. reward (comparative) performance - younger employees will have greater incentive to perform to the best of their abilities if they see that senior employees do not have an unfair advantage. However, a highly competitive culture can very quickly become toxic, so maintaining the right balance ensures a positive atmosphere.
- Job security (tenure) vs. competitive selection - to enhance job security, some firms tenure so that employees won't lose their jobs even if they are underperforming. While in other firms, only talent and highly productive persons can be hired, which creates a competitive environment within the firm.
- Intrinsic motivation vs. extrinsic rewards - some firms have the culture that makes the workers appreciate what they do and obtain a sense of achievement out of their jobs (intrinsic motivation), while other firms encourage high performance by offering pecuniary rewards (extrinsic rewards).
- Benefits and entitlements vs. additional pay - at some point higher pay levels will not contribute to employee satisfaction, so ensuring that the organisation provides additional benefits to the job allows for greater satisfaction, productivity and retention. Benefits can come in a wide variety of forms, such as a company car, health insurance, or even in-house benefits such as recreational facilities and employee support mechanisms such as counseling and support groups.
Consistent Human Resource Practices[edit | edit source]
HR managers should display consistent practices to reinforce the company's culture and messages.
- In forms of performance appraisal, recruitment, training, promotion and compensation, the HR system should follow the same procedure to show consistency. Procedurally:
- All workers should be treated equally.
- An employee should be treated in the same manner over time.
Following the procedure above, the consistency of HR practices has the following benefits:
- Technical (economic) benefits
- Displaying consistent HR practices reduces the administration costs.
- Psychological benefits
- Consistent messages allows easier learning as information is recalled better. It clearly outlines what an employee can expect from the firm and what the firm expects of them. Consistency leads to an stronger learning environment.
- Social benefits
- Consistent messages can create group norms (common language, jargon, etc.).
- Recruitment benefits
- Lowers employee dissatisfaction as they are better-fitted for the job. Hence, this decreases employee turnover.
- Employee morale
- Reduces social comparison as all workers are treated equally and similarly overtime (less resentment).
Measuring Consistency of Human Resource Practices[edit | edit source]
Measuring the consistency of human resource practices is vital to any organisation that wishes to exploit the benefits associated with these activities.
An investigation conducted by James Baron in 1999 (Baron, 1999) stated that there are two categories associated with measuring the consistency of human resource practices within an organisation. These are:
1. Measuring consistent human resource practices relevant to employees over a period of time.
2. Measuring consistent human resource practices relevant to technical complementarities among policies and practices.
Measuring employee consistency involves the implementation of similar practices and treatment among "similarly situated employees." These are, generally speaking, employees who perform extremely similar tasks, have the same responsibilities and have similar performance evaluations (i.e. are equally good at their jobs). In addition to implementing similar practices and treatment among employees, employee consistency can also be measured by evaluating the continuity in an organisation's HR philosophy over time.
In regards to technical complementaries, consistency is measured by how a potential policy or practice will affect the cost and benefits of other current HR activities. An example of this could be the effect of a new training program on the returns from other current HR activities such as recruiting new employees, improving job security, etc.
While it can be challenging to measure these consistencies qualitatively, many recurring themes are often used to identify levels of consistency among human resource practices. Some of these include evaluating whether;
- A firm presumes trust or distrust between employees and managers
- A firm assumes an employee is self-motivated and genuinely wants to do good work or if they assume they shirk and will work only under conditions controlled either by the promise of incentives or fear of consequences.
- There is a focus on groups or individuals in regards to key organisational structure
- A firm's overall goal is viewed as being devoted entirely to making money or serving a higher purpose (such as improving social and environmental settings)
In summary, if the benefits of consistent HR practices are to be exploited, then it is crucial to convey clear, consistent messages relevant to these themes so that employees will understand what is expected of them.
Can be challenging to measure consistency. Hiring rates can be a good idea - increasing turnover rates can lead to inconsistent practices.
- Qualitative evaluation of the uniformity of practices and treatment of similar employees and the continuity in HR philosophy over time
- Technical complementarities: how does a new policy/practice affect the costs and benefits of other HR practices? Could potentially not be aligned or following the same philosophy.
• Hiring employees
The main economic challenge in hiring employees is one of matching employee skills based on extensive and costly searches and inadequate information (World Economic Forum, 2014). Potential employees usually have varying levels of skills and the motivation to work, while organisations usually have different needs for these attributes. Therefore, economic efficiency requires that the existing labour market effectively links employees to suitable companies. The challenge to match both parties is further increased by the fact that companies and employees cannot cheaply observe all the pertinent characteristics of each other. Additionally, companies and potential employees can misrepresent their ability to be quality and efficient partners (Lazear & Gibbs, 2014). This is because potential employees sometimes use fictitious resumes or credentials, while companies might conceal some unpleasant aspects of an advertised job. Companies, therefore, seek employees who complement and are specifically matched to their needs (Lazear & Oyer, 2007). For instance, an information technology (IT) job requires the company to hire an individual who possesses high skill levels. On the other hand, companies could hire employees based on specific needs on a combination of skills. For example, a manager in an IT company might require skills in Java programming, taxation, and economics. Such skills are general because each of them might be valuable to other companies. However, there might be no other company which specifically requires that an employee must have all the skills at once. For instance, a real estate business might require the manager to possess skills in tax law and economics, but not Java programming. As such, an employee with all these skills who loses his job might be based on the labour market and search costs, find it difficult to get a job that requires all these skills (World Economic Forum, 2014). Consequently, he might receive lower wages.
• Labour contracting services
Labour contracting services such as subcontracting and outsourcing enable an organisation to reduce its overall cost. Subcontracting refers to the practice of bringing in external professionals to perform specific tasks in an organisation's project (Guers, Martin & Wybo, 2014). This usually happens when the company does not have its own skilled labour to do the work. However, the external professional and the hiring company work closely during such a project, and the company maintains some control over the entire process. On the other hand, outsourced tasks are those that a company’s own staff is capable of doing but chooses to let external professionals handle it so that its own staff is reserved for more important tasks (Goldschmidt & Schmieder, 2017). This mode of labour contraction provides a company with a cost-efficient solution for reducing its overhead, salaries and operating expenses to a minimum. For instance, a company can hire external professionals to handle its administrative work so that its own staff can handle marketing duties. In such a labour model, the external professional or third party works independently on the project and only communicates when necessary. As such, they maintain full control over the entire process. In reality, outsourcing and subcontracting are controversial topics due to their blurred distinctions. Instead of allowing internal staff to perform other tasks, some companies fire the staffs and then outsource all the jobs to be performed by external professionals (Goldschmidt & Schmieder, 2017). Personnel economics is an important factor in the success of firms. Therefore, firms need to make sure that they use the most effective strategies to ensure they enhance employee productivity and motivation. These include hiring and retaining skilled workers, incentivising and compensating them, rewarding excellent performance, and enhancing teamwork. This ensures that the firm retains a competitive advantage and long term growth.
Summary[edit | edit source]
The below section aims to briefly summarising the key takeaways from this topic:
Human Resources: the department in a firm who’s job is to hire and retain employees. To do this effectively they need to remain consistent and choose a strategy dependant on how they wish to run their firm.
Misaligned Incentives: Managers' incentives may not be aligned with those of the workers. This can lead to adverse selection (‘who do I hire?’) and moral hazard (‘how do I motivate agents to achieve my goals?’).
Motivation issues can be resolved by providing incentives to do well and giving KPIs. Empirically, it is found the more trust that employees are given, the more incentive they have to do well. In other words, when a person enjoys a job or career, this can be ruined by the fact that they have strict goals and requirements as it demoralises ambition and motivation.
Hidden Cost of Control: control entails hidden costs since most agents reduce their performance as a response to the principal’s controlling decision. Principals seem to anticipate the hidden costs of control and decide not to control.
Pay for performance: some firms set their employees payment to a structure where their efforts are rewarded based of what they achieve. This is good as it can attract highly motivated workers. However, there are cases where demand and economic limitations may limit the performance of an individual beyond their control, which is not desirable. Another issue is short term goals are incentives rather than long term goals as these are harder to measure, jeopardising LR prospects of a firm. Payment may have the opposite effect and take away people's love for something the more it feels like a job.
Power Law / CEO Pay: The model implies that the CEO pay is proportional to the firm size with respect to the industry and the industry as a whole.
Economics of Superstars: small difference in talent results in very big differences in pay as money is unbounded.
Tournament Theory: Increase in pay that goes with promotion is the reward for doing well to date
Team Production: Teams suffer from the free-rider problem. Teams should be used when each individual has specialised skills are in different areas (rather than overlapping skill sets) and can allow for a bigger problem solution from fewer team members.
Organisational Behaviour (OB): The use of scientific observation, particularly relating to the study of how people behave in groups, to create theories around business structure and decision-making. Limited use of statistical methodologies and economic principles.
Human Resource Management (HRM): The function within an organisation that focuses on the recruitment, management, direction and guidance of human capital. Focuses on creating competitive advantage through providing the necessary knowledge, tools and training to the people of an organisation. No use of statistical methodologies or economic principles.
Reference/s[edit | edit source]
- Graves, L., Sarkis, J. and Zhu, Q. (2013). How transformational leadership and employee motivation combine to predict employee proenvironmental behaviors in China. Journal of Environmental Psychology, 35, pp.81-91.
- Basford, T. and Offermann, L. (2012). Beyond leadership: The impact of coworker relationships on employee motivation and intent to stay. Journal of Management & Organization, 18(6), pp.807-817.
- Laura Langbein (2010) “Economics, Public Service Motivation, and Pay for Performance: Complements or Substitutes?” International Public Management Journal 13:1, pp. 9-23
- Shaw, E. P. (2007). Personnel Economics: The Economist's View of Human Resources. Journal of Economic Perspectives, 91-114.
- Goldschmidt, D., & Schmieder, J. F. (2017). The rise of domestic outsourcing and the evolution of the German wage structure. The Quarterly Journal of Economics, 132(3), 1165-1217
- Guers, C., Martin, C., & Wybo, J. L. (2014, September). The impact of the use of subcontracting on organizational reliability and safety. In 24th European Safety and Reliability Conference-ESREL 2014 (pp. 1027-1035). London, Taylor & Francis Group.
- Lazear, E, P. & Gibbs, M. (2014). Personnel economics in practice. 3rd Edition. Wiley.
- Lazear, E. P., & Oyer, P. (2007). Personnel economics (No. w13480). National Bureau of Economic Research.
- World Economic Forum. (2014). Matching skills and labor market needs. Global Agenda Council on Employment. Retrieved from http://www3.weforum.org/docs/GAC/2014/WEF_GAC_Employment_MatchingSkillsLabourMarket_Report_2014.pdf
Aftab Tariq Dar et al., 2014. MEDIATING ROLE OF EMPLOYEE MOTIVATION IN RELATIONSHIP TO POST-SELECTION HRM PRACTICES AND ORGANIZATIONAL PERFORMANCE. International Review of Management and Marketing, 4(3), pp.224–238.
Frank, R. (2003). What Price the Moral High Ground? . Ithaca, New York: Connel University . p 3-7
Kjell Arne Brekke, K. N. (2004). Moral hazard and moral motivation:. Oslo: Department of Economics, Univsersity of Oslo. p 2-5