Alternative Pay Schemes and Labor Efficiency

Labor Economics

Alternative Pay Schemes and Labor Efficiency

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The chapter commences be helping the student relate to the importance of payment schemes as well as the components and efficiency of a wage system. The author introduces the concepts with the real life example of a graduate student, seeking a position and needing to be informed.

Economics of fringe benefits

Fringe benefits refer to those additional services the employee will receive, aside the average salary and may refer to components such as social security, unemployment compensation or the employee’s compensation, such as premiums and bonuses. The importance of fringe benefits has grown significantly throughout the past recent years and so has their financial proportion in the overall compensation costs. In 1929 for instance, fringe benefits accounted for an estimated 3% in all compensation costs; in 2006 on the other hand, these benefits accounted for more than 25%.

Theory of optimal fringe benefits

As the composition of fringe benefits has changed, so has the response received by the employee. Otherwise put, employees will receive different utility and will register different satisfactions relative to the benefits packages. These are best explained with the aid of the worker’s indifference map. This map is represented by curves, aligned from left to right; the curves on the right offer increased utility and are therefore sought by the employee. On the other hand, the employer will seek to reduce these expenditures with fringe and wages in order to ensure increased profits. This is best revealed by the employer’s isoprofit curve, which sees that the most desirable level of investment in the human resource is reached when the isoprofit curve meets the highest point of the employee’s indifference curve.

The increase in fringe benefits produces a higher level of employee satisfaction and this can often be achieved without major efforts from the employer. Such situations refer to tax advantages, increased efficiencies or the creation of economies of scale.

The principal-agent problem

The principal is the organization, which follows to register profits. In this however, they need the support of the employees, or the agents, who are hired by the principal to make products and services which are then transformed into profits. The agents become employees because they need the wage and the benefits to sustain their living standards. As a result, the principal-agent relationship is based on mutual interest. The problem in this relationship occurs when the goals of the two parties begin to diverge. In this instance then, while the companies remain focused on profit registration, the agents become more focused on achieving increased utility. The problem arises when the employees pursue other goals than those promoted by the principal.

Pay for performance

In order to better stimulate the employees to increase their on the job performances, organizations have implemented various pay schemes based on the results retrieved by the employees. These have become extremely popular in the business community and refer to systems such as piece rates, commissions and royalties, promotions, raises, premiums, profit sharing or tournament pay.

Piece rates ensure a payment in accordance to the personal output realized by an employee. Commissions and royalties base the salary on the volume of sales finalized by the employee in a base period. Raises and promotions are often granted to employees who work on a fixed pay and can bring into discussions matters of incentives or annual salary. The bonuses are offered based on personal, team or organizational performance. Profit sharing means that employees can purchase corporate stocks and participate to profit sharing. Finally, the tournament pays are based on relative performance.

Efficiency wage payments

The performance-based wage systems are only useful within organizations that can easily quantify the efforts and results of their staff members. In some cases however, this is impossible. To overcome the impediment, an efficient remuneration scheme could be based on the monitoring of the personnel efforts. The efficiency wage model points out that principals should increase wages up to the point where employees’ efforts are maximum.

Chapter 8: The Wage Structure

The labor force presents the individual with a wide array of wage possibilities, in the meaning that one employee could make $2 million a year, whereas another can make$13,000. The differences which explain the differences can be equilibrium wage differentials or transitional wage differentials.

Perfect competition: homogeneous workers and jobs

The perfect competition and the homogeneity of workers and jobs results in equal access to information, an equitable distribution of jobs and equal salaries for all employees.

The wage structure: observed differentials

Historical observation of economic factors reveals that wage differentials do exist and they tend to persist over the time. Management employees for instance earn the highest incomes, whereas the workers in agriculture are seated at the opposite extreme. Another differential is given by location. In this order of ideas then, the employees in Connecticut register the highest incomes whereas those in Mississippi register the lower hourly pay. Within the industry sector, the highest wages are earned by the mining workers and the lowest by those working in agriculture.

Wage differentials: heterogeneous jobs

The actual market presents heterogeneous jobs, rather than homogeneous ones and they differ due to the skills required, non-financial attributes or productivity. Compensating differentials refer to the nonwage benefits granted due to the unpleasant feature of a particular job, such as risk of injury or even death, job status, location or security, as well as the prospect of wage advancement. Skill differentials occur when employees need various skills to complete the tasks of a job, such as college education vs. high school diploma. But differences also occur for workers with similar skills; these can be explained through the efficiency of wage payments. Other differentials emerge from the union status, the discriminatory behavior or the size of the employing organization.

Wage differentials: heterogeneous workers

These differences are given by varying productivity levels of employees, as well as by their varying preferences fro nonwage aspects. Within a noncompeting group, the varied human capital can be determined by different innate skills and abilities to learn and perform, as well as by physical or intellectual limitations or capabilities. Also, the differences reside in the training and education they acquire along the years. Outside of the noncompetitive market, differences may occur due to individual preferences on time spending or nonfinancial aspects of the employment contract.

The hedonic theory of wages

The hedonic theory of wages starts at the premises that both workers and jobs are heterogeneous. It emphasizes on the idea that employees will seek to increase utility, by conducting more operations which bring them pleasure. They will even exchange some of these utilities in order to reduce those activities which bring them disutility, in the form of pain or discomfort. The hedonic indifference map presents various curves, all revealing various degrees of utility. The curves towards the right offer the highest utilities. The isoprofit curve reveals the efforts an employer has to make in order to reach a desired level or profitability and also ensure employee utility.

Wage differentials: labor market imperfections

Aside from the heterogeneity of workers, organizations and jobs, differentials can also be generated by market imperfections. These pose difficulties as they impede the proper circulation of capitals. Becoming informed in the market place is time and money costly. This further reduces the possibility of achieving equilibrium on the labor market. Equilibrium will be reached within a group, but not at the level of the entire market. Then, as the information is not evenly distributed, the players in the labor market encounter time challenges to adjusting the differences.

Aside an uneven distribution of information, labor immobility is yet another generator of wage differentials. They generically refer to inabilities in properly moving within the labor market and can be classified into geographic, sociological or institutional immobilities.

Chapter 9: Mobility, Migration and Efficiency

The mobility and migration of the workforce, alongside with the adherent efficiency are three concepts noticeable within the economics of labor market.

Types of labor mobility

There are a wide variety of changes which determine employee mobility. Four of the most important ones are succinctly presented in the lines below:

change of job, without change in residence or occupation change in occupation, without change in residence change in the place of work, without change in occupation migration, change in residence, followed by a consequent change in occupation

Migration as an investment in human capital

The movement of the human capital can be seen as an investment as long as the employee is recognized to be the result of previous experiences and acquired skills. To better understand then, migration offers increased changes for professional development, producing a highly skilled worker. However, the phenomenon does imply additional costs and not all employees or employers will vote in favor of it.

The determinants of migration: a closer look

The ultimate decision in favor or against migration is given by a comparison of the costs and benefits, alongside with a consideration of the future increase in income which could be generated by the migration. However, other factors must also be considered. They refer to age, family, education, distance and unemployment.

The age factor points out that younger people are more likely to migrate than older workers. This can be explained by the fact that the elderly have fewer years in which to benefit from the migration investment and that they often possess skills valuable for their current employer. The familial forces reveal that the risks associated with moving increase with the size of family; otherwise put, a family of two is more likely to move than a family of five. The educational features highlights that the higher educated the subject is, the more chances are he or she will migrate. The distance force points out that while the distance is short, the worker will vote in favor of migration; on the other hand, if the distance is longer, he will manifest reticence to moving. Ultimately, the unemployed people are more likely to migrate than the employed ones.

The consequences of migration first set of consequences are felt by the individual. In this order of ideas, the income of the mover is highly likely to increase. The estimated return on the investment is between 10 and 15% and in actually measuring it for each individual, one must also account for the uncertainty and the uneven distribution of information, the timescale of the earnings, the income registered by the spouse, earning disparities or wage reduction as a result of downsizing. Then, in terms of the effects upon the labor markets, studies have revealed an increase in job allocation efficiency, combined with a narrowing of the wage.

But despite the above presented benefits of migration, the phenomenon is still frowned on. This could be explained by the negative consequences it generates, such as a misallocation or extensive use of resources, leading to negative impacts upon the natural environment (i.e. water pollution).

Capital and product flows

The migration of the labor force is also influences by less direct forces, such as the flows of other capitals and manufactured items. The author best explains this relationship by exemplifying the cases of the United States and South Korea. Since the U.S. wage rates are considerably higher than those in South Korea, two situations are likely to occur:

capitals will flow from the United States to South Korea the products made in Korea will be significantly cheaper

Whichever the most prominent situation, fact remains that the demand for jobs in the U.S. will decrease, whilst the demand on the South Korean labor market will increase. Therefore, the differential on wage will narrow and no labor migration will occur.

Chapter 10: Labor Unions and Collective Bargaining

The tenth chapter commences by stating the sensitivity of the topic on unions, revealing that just like any astringent social or political matters, individuals may share different, if not opposing views.

Why unions?

The need for unions arose with the massive industrialization of labor. To better explain, in the time when agriculture was the most important source of income and commodities, farmers were both employees and employers; they were self-sufficient. As industrialization occurred however, the people came to depend on factory owners for their incomes. As such, they needed unions to promote and protect their rights.

Labor unions: facts and figures

The appurtenance to a union depends on various factors, such as industry and occupation, geographic location or personal characteristics of the employee. The industry and occupation force reveals that most employees belonging to unions are present in public administration, transports, information and public utilities. At the other extreme sit the employees in agriculture, the retail personnel and the employees in finance, insurance and real estate. In terms of personal characteristics, males are more likely to belong to unions, as are African-Americans or the individuals over the age of 25. In terms of geographic location, the least unionized workers leave in the southern part of the country. New York, California, Pennsylvania, Illinois, Ohio and Michigan are the most heavily industrialized states and account for half of the unionized workers across the U.S.

The American unions are organized into three categories: federation (AFL-CIO), national unions and local unions.

Unionism’s decline

By 2006, within the agricultural sector of instance, only 11% of the workers had subscribed to unions. One can then observe that unionized labors are in minority. And not only this, the tendency is that of a historical decline. The structural change hypothesis forwards the idea that the decline is based on a variety of changes affecting the economy and the labor force. These changes could include modifications in consumer demands, the emergence of small economic entities which do not unionize, or the fact that the growth of the labor market has been based on more jobs for women and other groups, which have proven difficult to organize under the umbrella of a union.

Another hypothesis suggests that the decline is in fact due to the oppositions forwarded by the organizational management. The substitution hypothesis sees that the benefits for which the unions have been struggling are now being offered by the government and other institutions and this is then why the need for unions decreased.

What do unions want?

The historical response to the posed question is that the unions generally fight for better wage and employment conditions for their members. Some unions however strive to achieve monopoly, but this has yet to prove an efficient economic model. The more suitable alternative would be that of following efficient contracts, which increase the utility for both parties involved.

Strikes and the bargaining process

Strikes generate financial losses for both union and employer; therefore, most conflicts are settled without the occurrence of strikes. Most disputes are addressed through bargaining and whenever a strike occurs, it the result of an inefficient bargaining process. For instance, when one party is unable to properly identify the intentions of the other party, an incidental strike occurs. When the parties use different pieces of information, the strike created are called asymmetric.


McDonnel, B.M., 2008, Contemporary Labor Economics, 8th Edition, the McGraw Hill Companies

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