L03 04 Theoretical foundations of C&B Flashcards
What are the 5 characteristics of a competitive labor market?
-
People are homogeneous and thus interchangeable: No person-specific skills
2) Pay rates reflect all costs associated with employment: Base, incentives, bonus, …
3) Markets are competitive: No advantage for a single firm to pay above or below the market
4) Perfect information: all firms and workers have perfect information about jobs, skills and wages
5) ‘Equilibrium’ wage and employment level: In the equilibrium workers are hired by all firms.
What is measured by the labor demand and how is it influenced by 2 aspects?
It’s a measure of marginal productivity of labor (additional output of adding one unit of labor)
1) More human capital -> higher marginal productivity -> higher demand and wages
2) Labor is scarce (abundant) -> high (low) marginal productivity -> high (low) demand and wages
What is measured by labor supply and how do wages influence it?
It’s a measure of people’s willingness to work at a given wage
Wages are low (high) -> few (many) people will want to work: concept of reservation wage
What is the equilibrium wage?
… Wage level at which labor demand (#workers demanded) = labor supply (#workers willing to work)
Sketch the labor market equilibrium.
What is the reservation wage?
Job seekers have a reservation wage level below which they will not accept a job offer.
Why do wages differ? (4 reasons)
1) Institutions
2) Compensating wage differential
3) Information asymmetry
4) Moral hazard
Why wages differ: What is the role of institutions?
Institutions distort the equilibrium via legal, political and social arrangements by
1) Controlling demand (e.g. minimum wage above equilibrium->some willing workers and firms are not able to transact)->unemployment
2) Controlling supply (e.g. migration restrictions, unions)
Why wages differ: What is the role of compensating wage differential?
Employers must offer higher wages for negative job features:
Equally-skilled jobs may vary in other aspects that need to be compensated for (e.g. pleasantness, risk, prestige).
Why wages differ: What is the role of information asymmetries?
- *Firms cannot observe the productivity of potential workers**
- > Workers signal their productivity by acquiring education
- > Firms screen workers for their productivity using interviews, assessments, probation periods,…
- *Implication**: Firms with better (less good) screening hire more (less) productive workers and pay more (less)
Why wages differ: What is the role of moral hazard (Assumptions, Problem, Solution)?
- Assumptions: Worker max. utility (work as little as possible) and firm max. profits (wants the worker to work as hard as possible)
- Problem: Worker’s effort is typically not perfectly observed
- Solution: Use of incentives to align interests
Incentives: the basics. What is the logic behind effort, output and wage? What problem arises?
Higher effort => higher output
Worker: Effort is costly and must be rewarded with higher wage
Firm: Limited observability of effort, thus needs proxies for effort.
Incentives: What can firms do if they don’t observe the effort level?
Proxy 1: Detect shirking while monitoring => ‘efficiency wage’
Proxy 2: Use actual performance due to the logic that higher effort leads to better performance => higher ‘performance-based pay’
What is the efficiency wage?
… the wage that keeps workers just from shirking.
It is always above the equilibrium wage level.
Efficiency wage: State the no-shirking condition.
The worker will work if:
w-c ≥ pw0 + (1-p)w
<=> p(w-w0) ≥ c
Efficiency wage: Explain the variables used as well as their impact on the level of the efficiency wage.
w: fixed wage
c(+): effort costs
p(-): probability that shirking is detected
w0(+): equilibrium wage
Efficiency wage: What is the trade-off to meet the no-shirking condition?
Pay higher w and thereby reduce monitoring costs for same p
vs.
Intensify monitoring to yield higher p and thereby can afford to pay lower w
=> Firms choose (p,w) such that the no-shirking condition just holds: p(w-w0) = c
Efficiency wage: What is the implication of screening on w?
Implication:
Selection/screening may decrease w as high-ability workers have lower c.
Be careful: Better selection/screening requires higher recruitment and screening costs.
Utility analysis of selection: State the utility function u from job applicant selection and explain the variables as well as their impact on u.
u = r x SD x Z - C/SR
r(+): correlation between assessment result and future performance (how accurate assessment is)
SD(+): standard deviation of the value in performance (how much difference in value is created by a one-SD difference in performance)
C(-): recruitment and assessment costs per applicant
SR(+/-): selection rate 0 < r < 1. Higher SR leads to higher Z(+), because of more applicants, but also higher C/SR(-)
Z(+): mean standard performance score of those hired (by how many SDs of performance those hired exceed the rest). For Z look into N(0,1) distribution table @SR.
Utility analysis of selection: Give an example of tougher selection.
Assume r=0.4; SD=$50,000; C=$200; SR=0.5; Z=0.8
Mechanism: Pay higher wage of $10,000 for a given vacancy leads to lower SR=0.05 due to more applicants.
u(before) = 0.4 x 50,000 x 0.8 x 200/0.5 = 15,600 per hire
u(after) = 0.4 x 50,000 x 2.06 - 200/0.05 = 37,200 per hire
=> utility gain from tougher selection = u(after) - u(before) - additional wage = 37,200-15,600-10,000 = $11,500 per hire
Not taken into account:
Turnover would increase and thus SD as the time horizon rises. Additionally, monitoring costs decrease due to higher wage
Utility analysis of selection: Give an example of a more accurate assessment.
Assume r=0.4; SD=$50,000; C=$200; SR=0.5; Z=0.8
Mechanism: Better screening technology leads to r=0.8 and C=$300.
u(before) = 15,600 per hire
u(after) = 0.8 x 50,000 x 0.8 - 300/0.5 = 31,400 per hire
=> Utility gain from more accurate assessment = 31,400-15,600 = $15,800 per hire
Additionally, monitoring costs decrease due to higher average quality of hired applicants.
Model of performance-related pay: Assumptions (5)
1) No intrinsic motivation, only money motivates
2: A’s effort e is not observable
3) A produces output y = e + η with E(η)=0
4) A max. w = a + b * y
5) P max. π = y - w
Model of performance-related pay: State the agent’s participation constraint and derive his optimal choice of effort level?
PC: u = E(w=a+by) - δe2/2 - λvar(w|e) ≥ ū
δe2/2: effort cost
λ: dislike of earnings’ uncertainty (=risk-aversion)
ū: reservation utility
max. u wrt. e yields optimal effort level e*=b/δ
Model of performance-related pay: What are the principal’s actions, what a chooses P?
P anticipates A’s effort choice e*= b/δ
P max. π = b/δ - a - b2/δ
P chooses a = ū - b2/2δ + λb2σ2 to just satisfy A’s PC
Thus, π = b/δ - ū - b2/2δ - λb2σ2
Model of performance-related pay: What are the results (b*,a*,e*, π, u)?
Model of performance-related pay: What is the incentive effect?
If b=0, e=0
If introducing incentive pay (b > 0), e↑ (incentive effect)
Workers with lower δ (hard-working workers) and/or lower λ (less risk-averse): e↑↑
Sum of individual outputs ↑
Model of performance-related pay: What is the sorting effect?
Assumption: Free workers on the labor market
After the introduction of incentive pay:
Low-δ and low-λ workers will come and high-δ and high-λ will leave (sorting effect)
Sum of individual outputs ↑ and π ↑
5 Factors affecting the design of an incentive pay scheme
1) Firm size: Smaller firms can monitor easier and thus need incentive pay less.
2) Risk/loss aversion: Reduces the effect of incentive pay since there are extra costs of risk beared by employees.
3) Uncertainty of output σ: The higher σ, the lower the optimal strength of incentives, the less effect has incentive pay.
4) Dysfunctional behavioral responses (e.g. credit sold to not creditworthy customer): Reduce applicability of incentive pay and/or call for reappraisal of performance criteria.
5) Individual/team-based incentives: Individual incentives discourages cooperation, team-based incentives may invite free-riding. Reputation and peer pressure are important for the success of incentive pay.
Is incentive pay the first-best compensation scheme?
Under first-best scheme, the risk is borne by the party with highest risk attitude.
A bears some risk through b and bearing risk is more expensive than for P.
=> Incentive pay implies efficiency loss when A is risk-averse
=> Under first-best, P would pay A based on effort e - Due to unobservability unfeasible
=> Incentive pay is second-best scheme
6 variants of incentive pay
1) Residual claimant schemes: e.g. taxi driver A pays fee to owner of the car P and takes all the revenue (only for risk-neutral A)
2) Fixed wage a + payment per unit of output produced
3) Fixed wage + target bonus as a fraction of wage or output
4) Stock options given to employees, that often can only be converted into cash after some years.
5) Deferred compensation: Pay less than productivity early in career, pay more than productivity later on. Incentive: stay on the job long enough.
6) Bonus or promotion for winning a tournament: In tournaments, relative performance counts - great way when output is hard to measure.
