Employee turnover has always been a looming threat to business. Hiring new employees and retaining the ones the company already has, both share a vital point: employee satisfaction. Show
The two essential elements that factor into an employee's decision to stay with an organization are whether the company values them, and how much they get paid. In some cases, these elements create a sense of loyalty to the business as well. How does a company ensure that its staff feels valued and adequately compensated? Thirteen professionals from Forbes Human Resources Council explore some methods a business can undertake to ensure employees feel crucial to the company's success. Photos courtesy of the individual members1. Have An Honest Conversation Employers should have an honest conversation during the recruitment process about the candidate's compensation expectations and the company's ability to pay. The company should offer compensation that is competitive based on the job market and their ability to pay. Candidates should be allowed to discuss what compensation works for them based on their expectations, skills and experience. - Ochuko Dasimaka, Career Heights Consulting, Inc. 2. Stay On Top Of The Market Invest in salary surveys and benchmarking, and review how roles stack up against market at least once or twice a year. While it may not be an exact science, this can help indicate whether you are paying more or less than other organizations for a similar role (and what your employees might see as their earning potential elsewhere). This also helps increase employees' perceptions of fairness. - Lindsay Putzer, Curology 3. Utilize Salary Surveys And Research Basing salaries on past salary history has traditionally led to income inequality and contributed to the gender pay gap. Now that many states and cities have banned the practice, employers can use salary surveys to ensure workers are paid fairly based on their job duties and qualifications. Furthermore, they can research salary ranges on sites such as Glassdoor and Salary.com to ensure fairness. - John Feldmann, Insperity 4. Balance Expertise, Potential And Market Value Experience and expertise are only part of the equation. Using multiple perspectives provides clarity for an employee's market value. A clear, objective definition of potential helps managers avoid bias, underestimation and overestimation when considering compensation. Higher potential employees know their worth, so having a strategy to pay them starts with how they are identified and managed. - Jessica Delorenzo, Kimball Electronics Inc 5. Ask And Individualize Throughout the interview process, have clear conversations with candidates about their compensation needs and expectations. Ask them about which compensation elements are most important to them. Compensation is emotional and individual. Using a boilerplate approach will ensure that almost no one is satisfied. Think beyond traditional compensation elements to individualize rewards and make them meaningful. - Max Hansen, Y Scouts 6. Know What Matters To Them Knowing what is important to individuals as they go through the candidate experience is key to ensuring your offer will be attractive now and throughout their employment. With experienced executives, their needs can be very different than emerging leaders or recent grads. Having options, such as long-term incentive plans or tuition reimbursement, can allow companies to attract the best talent. - Shelli Nelson, Madison Industries 7. Have A Clear Compensation Strategy Compensation inequality is a real problem in today's workforce. Using Glassdoor, LinkedIn Salary or PayScale to benchmark against market competitors is a wise move. A clear compensation strategy can eliminate arbitrary salary decisions, and ensure employees are fairly compensated and valued. Additionally, a quarterly review of compensation can make sure there aren't major discrepancies. - Ray Ocon, Chasing Unicorns 8. Pay What It's Worth To You You can run market analysis and pay at a percentile of the market, but that isn't always a great short- or long-term strategy to retain people. Pay what the job is worth to you or the organization. If you have a team of experienced people, you can hire a less experienced person and pay less but if you have a team of newbies, you might want to pay the extra money for that experienced candidate. - Lotus Buckner, NCH 9. Understand And React To Employees' Needs What can't be matched dollar-to-dollar can be offset by pulling other levers, including flexibility, benefits, perks, growth opportunities, etc. Transparent policies and programs that reflect your employees' needs make it known that they're understood, heard and valued by their employer. Regular conversations and surveys asking for this type of feedback will allow employers to react appropriately. - Keri Higgins Bigelow, LivingHR, Inc. 10. Show Them The Total Package Too often, companies fail to communicate the total investment being made in an employee. Yes, salary is important and should be aligned to the market, but taking it a step further and showing individuals the total you're investing (salary, cash and non-cash incentives, benefits, L&D). Do this through total compensation statements for employees, and total investment outlines for candidates. - Charles Ashworth, Zendrive 11. Give Them A Compensation Preview Create steps in the hiring process that engage the candidate in a compensation preview. First share ranges and key elements of the compensation plan to set expectations. Ask the candidate for reaction and what they most value. Later, discuss specifics, including details like paid time off or 401(k) match. It’s a simple way to identify issues early on and reinforce the value of total compensation. - Karen Crone, Paycor, Inc. 12. Be Fair And Equitable In Your Pay Practices Being fair and equitable goes a long way for employees to feel valued, engaged and retained. Provide clarity on how employees are assessed and how raises, bonuses and other forms of rewards are earned, and ensure you are paying equitably for the same work, regardless if someone was compensated much lower in a previous company. - Danielle Monaghan, Uber 13. Seek Value Alignment Know what works for your organization and strategic goals, then screen candidates whose values align. A misalignment from forcing an anomaly in pay structure is destructive and rarely succeeds. Nonprofits may pay less but offer community. High risk and reward drive some, while steady compensation drives others. With strong alignment in the work and compensation, your employees will feel valued! - Liz Huldin, Catalytic Talent LLC
In March 2000, Terri Lawrence was driving her 1996 Ford Explorer SUV near Fort Lauderdale, Florida. ‘All of a sudden’, she said, ‘there was this explosion’. One of her tyres had blown out. The Ford Explorer flipped over, and she was badly injured. By the summer of 2000, with similar reports of blowouts and overturned Explorers accumulating, Ford convened a ‘war room’ to deal with the public relations catastrophe. They quickly determined that the Firestone tyres used on most Explorers were at fault. There were no unusual reports of blowouts on Explorers with Goodyear tyres. In August 2000, in partnership with Ford, Firestone recalled 14.4 million tyres. According to the US National Highway Traffic and Safety Administration, blowouts of the Firestone tyres in question had resulted in crashes that took 271 lives. In the four months following the recall, the market value of Firestone shares on the stock exchange dropped by $9.2 billion, to less than half of their value before the crisis. But the cause of the spate of fatal blowouts remained a mystery. High-speed stress tests confirmed that there was nothing wrong with the design of the tyres. An inconspicuous clue, however, pointed to ‘the scene of the crime’, if not its motive. On the sidewall of each of the blown-out tyres was a ten-digit tyre code, indicating the particular plant that had produced the tyre and the week of its production. Most of the faulty tyres had been produced at just one of Firestone’s six plants, located in Decatur, Illinois. Alan B. Krueger and Alexandre Mas explain how economists analyzed the tyre defects at the Decatur plant in ‘Strikes, Scabs, and Tread Separations: Labor Strife and the Production of Defective Bridgestone/Firestone Tires’. Journal of Political Economy 112 (2): pp. 253–89.” For years, the Firestone Decatur plant had been in the news for other reasons. In 1994, the company had imposed a 12-hour shift that rotated between night and day for each worker, replacing the historic eight-hour shift. New hires’ wages were reduced by 30%; vacations for more senior workers were cut by two weeks. On 12 July 1994, the United Rubber Workers union that represented the employees called a strike. The firm immediately hired 2,300 replacement workers, paying them 30% less than wages previously paid. Ten months later, the union called off the strike; returning workers accepted substantial pay cuts, a freeze in their pension benefits, and the 12-hour shifts. Bitterness toward the company and protests continued. Building tyres at the time was a labour-intensive and skilled occupation. A number of the union workers blamed lack of training and experience among the replacement workers for the tyre blowouts. William Newton, a senior tyre builder in Decatur, reported that he ‘saw a lot of people [working as replacements] who did not know how to build tyres’. But investigators looking at the detailed records of exactly when the faulty tyres were produced were in for a shock—virtually none of them had been produced during the strike, when Firestone was employing the replacement workers. Most of the faulty tyres had been produced by experienced union workers, both before the strike—when Firestone’s pay cuts, 12-hour shift, and other new demands had been announced—and after the defeat of the strike, when the union workers returned. While it cannot be proven, it seems likely that the permanent workers at the Decatur plant had retaliated against Firestone, devoting less effort to producing safe tyres, or even deliberately sabotaging production. The owners of Firestone discovered that they could indeed impose a 12-hour shift and a 30% pay cut, but they could not ensure that safe tyres would be produced if their employees were angry as a result. Firms are major actors in the economy; we will use this and the next unit to explain how they work. A firm is often referred to as if it were a person—we talk about ‘the price Firestone charges’. But, while firms are actors—and in some legal systems are treated as if they were individuals—firms are also the stages on which the people who make up the firm act out their sometimes common, but sometimes competing, interests. The people making up the firm—employees, managers, and owners—are united in their common interest in the firm’s success because all of them would suffer if it were to fail. However, they have conflicting interests about how to distribute the profits from the firm’s success among themselves (wages, managerial salaries, and owners’ profits); they may also disagree about policies (such as conditions of work and managerial perks) and who makes the key decisions (such as whether it was a good idea to impose a 12-hour shift on the Firestone workers in Decatur and cut their vacation times). In this unit, we focus on the firm as a stage and model the relationships among the key actors—employees, managers, and owners. We model how wages are determined when there are conflicts of interest between employers and employees, and look at what this means for the sharing of the mutual gains that arise in a firm. In Unit 7, we will look at the firm as an actor in its relationship with other firms and with its customers. division of labourThe specialization of producers to carry out different tasks in the production process. Also known as: specialization.firmsEconomic organizations in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.6.2 Firms, markets, and the division of labourThe economy is made up of people doing different things, for example producing Apple iPhones or making clothing for export. Producing smartphones involves many distinct tasks, done by different employees within the companies that make components for Apple—Toshiba or Sharp in Japan, or Infineon in Germany. Setting aside the work done in families, in a capitalist economy, the division of labour is coordinated in two major ways—firms and markets.
In this unit, we study firms. In the units to follow, we study markets. Herbert Simon, an economist, used the view from Mars to explain why it is important to study both. Trained as a political scientist, Simon’s desire to understand society led him to study both institutions and the human mind—to open the ‘black box’ of motivations that economists had come to take for granted. Herbert ‘Herb’ Simon (1916–2001) was celebrated in the disciplines of computer science, psychology, and, of course, economics, for which he won the Nobel Prize in 1978. The coordination of workThe way that labour is coordinated within firms is different to coordination through markets:
The prices that motivate and constrain people’s actions in a market are the result of the actions of thousands or millions of individuals, not a decision by someone in authority. Although the government can tax and regulate private property, the idea of private property specifically limits the things a government or anyone else can do with your possessions.
In a firm, by contrast, owners or their managers direct the activities of their employees, who may number in the thousands or even millions. The managers of Walmart, the world’s largest retailer, decide on the activities of 2.2 million employees, a larger number of people than any army in world history before the nineteenth century. Walmart is an exceptionally large firm, but it is not exceptional in that it brings together a large number of people who work in a way coordinated (by the management) to make profits. Like any organization, firms have a decision-making process and ways of imposing their decisions on the people in it. When we say that ‘Fiat outsourced its component production’ or ‘the firm sets a price of €11,200’, we mean that the decision-making process in the firm resulted in these actions. Figure 6.1 shows a simplified picture of the firm’s actors and decision-making structure.
Adam Smith, writing at the birth of capitalism in the eighteenth century, was to become its most famous advocate. Karl Marx (1818–1883), who watched capitalism mature in the industrial towns of England, was to become its most famous critic. Born in Prussia (now part of Germany), he attended the local classical high school, which was celebrated for its ethos of enlightened liberalism. In 1842, he became a writer and editor for the Rheinische Zeitung, a liberal newspaper, which was later closed by the government. After this, he moved to Paris and met Friedrich Engels, with whom he collaborated in writing The Communist Manifesto (1848). Marx then moved to London in 1849. At first, Marx and his wife Jenny lived in poverty. He earned money by writing about political events in Europe for the New York Tribune. Marx saw capitalism as just the latest in a succession of economic arrangements in which people have lived since prehistory. Inequality was not unique to capitalism, he observed—slavery, feudalism, and most other economic systems had shared this feature—but capitalism also generated perpetual change and growth in output.3 He was the first economist to understand why the capitalist economy was the most dynamic in human history. Perpetual change arose, Marx observed, because capitalists could survive only by introducing new technologies and products, finding ways of lowering costs, and by reinvesting their profits into businesses that would perpetually grow. Marx also had influential views on history, politics, and sociology. He thought that history was decisively shaped by the interactions between scarcity, technological progress, and economic institutions, and that political conflicts arose from conflicts about the distribution of income and the organization of these institutions. He thought that capitalism, by organizing production and allocation in anonymous markets, created atomized individuals instead of integrated communities. In recent years, economists have returned to themes in Marx’s work to help explain economic crises. These themes include the firm as an arena of conflict and of the exercise of power (this unit), the role of technological progress that we analysed in Unit 1, and the problems created by inequality that we saw in Unit 5. George Bernard Shaw (1856–1950), a writer, joked that ‘if all economists were laid end to end, they would not reach a conclusion.’ This is funny, but not entirely true. Read the ‘When economists agree’ box to see how Marx and Ronald Coase of the University of Chicago—two economists from different centuries and political orientations—came up with similar ways of understanding the power relations between employers and their employees.
Both Marx and Coase based their thinking on careful empirical observation, and they arrived at a similar understanding of the hierarchy of the firm. They disagreed, however, on the consequences of what they observed—Coase thought that the hierarchy of the firm was a cost-reducing way to do business; Marx thought that the coercive authority of the boss over the worker limited the employee’s freedom. Over this, they disagreed. But they also advanced economics with a common idea.
Contracts and relationshipscontractA legal document or understanding that specifies a set of actions that parties to the contract must undertake.The difference between market interactions and relationships within firms is clear when we consider the differing kinds of written and unwritten contracts that form the basis of exchange. A sale contract for a car transfers ownership, meaning that the new owner can now use the car and exclude others from its use. A rental contract on an apartment does not transfer ownership of the apartment (which would include the right to sell it); instead it gives the tenant a limited set of rights over the apartment, including the right to exclude others (including the landlord) from its use. wage labourA system in which producers are paid for the time they work for their employers.Under a wage labour contract, an employee gives the employer the right to direct him or her to be at work at specific times, and to accept the authority of the employer over the use of his or her time while at work. The employer does not own the employee as a result of this contract. If the employer did, the employee would be called a slave. We might say that the employer has ‘rented’ the employee for part of the day. To summarize:
Which of the following statements are true?
6.4 Other people’s money: The separation of ownership and controlThe firm’s profits legally belong to the people who own the firm’s assets, including its capital goods. The firm’s owners direct the other members of the firm to take actions that contribute to the firm’s profits. This, in turn, will increase the value of the firm’s assets and improve the owners’ wealth. There are thus two aspects of ownership of a firm:
Profit is the residual. It is what’s left of the revenues after these payments. The owners claim it, which is why they are called residual claimants. Managers and employees are not residual claimants (unless they have some share in the ownership of the firm). This division of revenue has an important implication. If the firm’s revenues increase because managers or employees do their jobs well, the owners will benefit, but the managers and employees will not (unless they receive a promotion, bonus, or salary increase). This is one reason we consider the firm as a stage, one on which not all the actors have the same interests. Owners delegate control to managersshareA part of the assets of a firm that may be traded. It gives the holder a right to receive a proportion of a firm’s profit and to benefit when the firm’s assets become more valuable. Also known as: common stock.In large corporations, there are typically many owners. Most of them play no part in the firm’s management. The owners of the firm are the individuals and institutions (such as pension funds) that own the shares issued by the firm. By issuing shares to the general public, a company can raise capital to finance its growth, leaving strategic and operational decisions to a relatively small group of specialized managers. These decisions include what, where, and how to produce the firm’s output, or how much to pay employees and managers. The senior management of a firm is also responsible for deciding how much of the firm’s profits are distributed to shareholders in the form of dividends, and how much is retained to finance growth. The owners benefit from the firm’s growth because they own part of the value of the firm, which increases as the firm grows. separation of ownership and controlThe attribute of some firms by which managers are a separate group from the owners.When managers decide on the use of other people’s funds, this is referred to as the separation of ownership and control. The separation of ownership and control results in a potential conflict of interest. Conflict of interest between owners and managersThe decisions of managers affect profits, and profits decide the incomes of the owners. But the interests of owners and managers will be in conflict because managers’ salaries and bonuses are paid from profits that would otherwise go to the owners. There are many things that managers can do to raise their pay at the expense of profits. For example, in firms listed on the stock market, managers’ pay rises and falls with the firm’s stock market performance over a period as short as a quarter or a year; there are many ways managers can boost the firm’s short-term stock market performance but damage the firm’s profitability in the long run. Managers are in day-to-day control of the firm’s assets and they may choose to take actions that benefit themselves, at the expense of the owners. An example is where managers seek to increase their own power and prestige through empire-building, even if that is not in the interests of shareholders. Even sole owners of firms are not required to maximize their profits. Restaurant owners can choose menus they personally like, or waiters who are their friends. But, unlike managers, when they lose profits as a result, the cost comes directly out of their own pockets. Although Adam Smith had not seen the modern firm, he observed the tendency of senior managers to serve their own interests rather than those of shareholders. He said this about the managers of what were then called joint-stock companies:
Aligning the interests of owners and managersThere are many ways that owners can incentivize managers to serve their interests. One is that they can structure contracts so that managerial compensation depends on the performance of the company’s share price over a lengthy period of time. Another is that the firm’s board of directors, which represents the firm’s shareholders and typically has a substantial share in the firm (like a representative of a pension fund), can monitor the managers’ performance. The board has the authority to dismiss managers. free rideBenefiting from the contributions of others to some cooperative project without contributing oneself.But although the shareholders, who are the ultimate owners, have the right to replace members of the board, they rarely do so. Shareholders are a large and diverse group that cannot easily coordinate to decide something. Occasionally, however, this free-rider problem is overcome and a shareholder with a large stake in a company may lead or coordinate a shareholder revolt to change or influence the board of directors and senior management. In spite of the separation of ownership and control, when we model the firm as an actor, we often assume that it maximizes profits. This is a simplification, but a reasonable one for many purposes:
Which of the following statements about the separation of ownership and control are true?
6.5 Other people’s labour: The employment relationshipfirmsEconomic organizations in which private owners of capital goods hire and direct labour to produce goods and services for sale on markets to make a profit.Most people who work outside the home have jobs in firms. Remember, a firm is a business organization that pays wages and salaries to employ people, and purchases inputs to produce and market goods and services with the intention of making a profit. A firm’s profits (before the payment of taxes) are equal to the money the firm receives from the goods or services, minus the costs of producing these goods and services. The wages and salaries paid to the people a firm employs are a large fraction of its costs. The profits received by the owners of the firm depend—among many other things—on how hard and well those employees work. In firms, the employer sets the wage, hours of work and working conditions. If you are an employee, the employer—whether an owner of the firm or a manager appointed by the owners—is the ‘boss’ who decides not only what you are to do on the job, but also whether you lose your job or are promoted. But, as an employee, you also have some power in this relationship. You can quit your job, which will mean the employer has to incur the costs of hiring someone else. You can also decide how much effort to put into your work, which is very important to your employer. employment relationshipThe interaction between an employee and an employer in which the employer sets the hours and other conditions of work and the wage, directs the employee’s activities and may terminate her employment, and the employee chooses how hard to work and whether to quit her job. The employee’s level of effort, or her decision to remain in the firm, are determined by the choices made by the two parties—and are affected by the exercise of power by the employer and the social norms of both parties.The ongoing interaction between an employer and an employee in a firm is called the employment relationship. While the wage and the hours of work are governed by an employment contract, and some other aspects of the job (safety conditions for example) may be stipulated by public policy, the employer sets the hours and other conditions of work, and can terminate the job. The employee decides on her level of effort, and whether to remain in the firm. Mutual gains and conflicts of interestFor an employer and an employee to remain in the employment relationship, both need to gain something compared to the next best alternative. For the firm this is to find, train and hire another worker. For the employee this is to find another job. We can infer two things from an employment relationship:
It is clear that both employees and employers benefit from the employment relationship. But just as in Section 6.4, where we found that there is conflict of interest between the owners of firms and their managers, there is also a conflict of interest between employers—owners and managers alike—and workers. The reason is that, in the simplest terms, owners want more employee effort at a lower wage, while workers want a higher wage for less effort. In this section and the next sections, we explain the factors that affect the wage set by the employer. We start with a basic fact: employers cannot simply order the worker to work hard, as a slave-owner might have done. The employer will need not only to look at this decision from both the perspective of the employee and employer. Why not pay workers piece rates?If the employer cannot force the worker to work hard, why do employers not simply buy the employee’s effort in the same way that they buy other inputs like energy or computers? If they could, they would pay employees using piece rates—for example, at a clothing factory the employers might pay $2 for each garment their workers finish. A piece rate is not a wage, because it is paid per unit of output (per piece) not per hour or day. piece-rate workA type of employment in which the worker is paid a fixed amount for each unit of the product that the worker produces.A piece rate provides the employee with an incentive to exert effort, because they take home more money if they make more garments. In the late nineteenth century, the pay of more than half of US manufacturing workers was based on their output, but piece rates are not widely used in modern economies. At the turn of the twenty-first century, fewer than 5% of manufacturing workers in the US were paid piece rates and, outside the manufacturing sector, piece rates are used even less often.10 Why do most firms not use piece rates?
A partial exception is today’s gig economy (see Section 6.14). Consider the case of Uber, Lyft, Deliveroo, and other delivery and transportation services. Unlike modern office, hospital, school and factory work, the job is typically done by an individual, working alone. The task to be completed is subject to contract because it is easy to determine whether it has been completed—the package, for example, was either delivered or not. But if piece rates are not practical in most of the economy, then production is carried out in firms with employees who have an employment contract under which payment is for time spent working, rather than for output. The employment contract is necessarily incomplete—after all, if a complete contract specifying every aspect of the worker’s output were possible, labour input would be purchased on the market under a piece-rate system. The employment contract is incompleteFrom the firm’s perspective, hiring employees is different from buying other goods and services. When an employer buys a fork-lift truck, or pays someone to audit the accounts, it is clear what the employer is purchasing. If the seller does not deliver, the employer either does not pay, or goes to court to get its money back. But an employer cannot write an enforceable employment contract that specifies the exact tasks employees have to perform in order to get paid. This is for three reasons:
To understand the last point, consider a restaurant that requires staff to serve customers in a pleasant manner. Imagine a court being asked to decide whether the owner can withhold wages from a waiter, because he had not smiled often enough. incomplete contractA contract that does not specify, in an enforceable way, every aspect of the exchange that affects the interests of parties to the exchange (or of any others affected by the exchange).An employment contract omits things that both the employees and the owner care about because they are central to the employment relationship—including how hard and how well the employee will work, and for how long the worker will stay. We call this an incomplete contract. As a result, paying the lowest possible wage is almost never the firm’s strategy to minimize the cost of acquiring the labour effort it needs. To see why, we need to ask why a worker puts in a good day’s work.
Which of the following statements regarding employment contracts are correct?
Which of the following are reasons why employment contracts are incomplete?
There are many reasons why people put in a good day’s work. For many people, doing a good job is its own reward, and doing anything else would contradict their work ethic. Even for those not intrinsically motivated to work hard, feelings of responsibility for other employees or for one’s employer may provide strong work motivation. For some employees, hard work is the appropriate way to respond to the employer for providing a job with good working conditions. In other cases, firms use performance-related pay to reward hard work. It is sometimes possible to identify teams of workers whose output is readily measured—for example, the percentage of on-time departures for airline staff—and pay a benefit to the whole group, to be divided among team members. These employees have a reason to work hard—they are paid for it. However, as we have seen, there is another reason to do a good job—the fear of being fired, or of missing the opportunity to be promoted into a position that has higher pay and greater job security. Laws and practices concerning the termination of employment for cause (that is, because of inadequate or low-quality work, not due to insufficient demand for the firm’s product) differ among countries. In some countries, the owners of the firm have the right to fire a worker whenever they choose, while in others, dismissal is difficult and costly. But, even in these cases, an employee has to fear the consequences of not meeting the standards that the employer sets. If this happened, she might lose her job if lower demand for the firm’s products results in workers being laid off.
Do workers care whether they lose their jobs? They would have no reason to care if they could immediately get another job at the same wage and working conditions. If this is not the case, then there is a cost to losing your job, as well as some benefits from not working. unemployment benefitA government transfer received by an unemployed person. Also known as: unemployment insurance.People who lose their jobs can typically expect help from family and friends while they are out of work. Also, in many economies, people who lose their jobs receive an unemployment benefit or financial assistance from the government. They may be able to earn a small amount in self-employment or by taking odd jobs. Figure 6.2 sets out the costs and benefits from having a job and compares them with the costs and benefits of not having the job, all on a daily basis. This is a hypothetical exercise from the perspective of someone with a job. utilityA numerical indicator of the value that one places on an outcome, such that higher-valued outcomes will be chosen over lower-valued ones when both are feasible.disutility of effortThe degree to which doing some task (effort) is unpleasant.In Column A are the monetary and non-monetary benefits and costs associated with having a job, and in column B, with losing that job. We use the concept of utility introduced in Unit 4. We can say that the worker’s utility is increased by the goods and services she can buy with her wage, but reduced by the unpleasantness of going to work and working hard all day—the disutility of effort.
In the top row, if you lose your job, you would lose the wage and instead get some unemployment benefit and financial assistance from family and friends. Although you would not have to pay travel to work costs, you would incur costs of searching for a new job, including possible retraining and relocation expenses. Costs and benefits are about more than money. On one hand you gain by being rid of the disutility of effort—you no longer have to get up for work, and have more free time—but on the other hand you may lose the esteem that comes with the job. Some jobs come with medical and other benefits, which you would lose. 6.7 Employment rentsTaking the employee’s perspective of how hard to work, the employer looks at Figure 6.2 and would like to find a way to make the worker love having her job, at least compared to the alternative. Many of the items in columns A and B of the figure are beyond the control of the employer. But one is not. The employer can set the wage so as to get a good day’s work from the employee. Because the employee cannot literally be forced to work hard, this requires that the worker be motivated to provide adequate effort on the job. This motivation is provided by both a carrot and a stick. employment rentThe economic rent a worker receives when the net value of her job exceeds the net value of her next best alternative (that is, being unemployed). Also known as: cost of job loss.
In Figure 6.2, the employee’s employment rent depends on the difference in how much the worker values entries in the first and second columns, multiplied by the length of time that the person expects to remain unemployed if she loses her job. To decide how much it is worth to her to keep the job at the wage offered in the employment contract, the worker has to think ahead: ‘How hard will I have to work, what is the chance of being sacked or not promoted for slacking on the job, and what are my prospects if I lose my job? It takes time to get another job and during that time, an unemployed worker relies on unemployment benefits and may lose other job-related benefits like a sense of making a productive contribution or health insurance. Also, if I lose my job now, the next job I find may pay less.’ If there was no carrot (employment rent), the employee would be just as happy to lose her job as to keep it. So the stick would be ineffective. If the employment rent is big enough, the employer gets a ‘good day’s work’ from the employee. Just as the owners of the firm protect their interests by linking management pay to the firm’s share price, the manager uses incentives so that employees will work effectively. Because the worker gets an employment rent (the carrot) and can lose her job (the stick), she does not want to lose her job or risk not being promoted and she will therefore exert effort on the job. To understand the employment rent and its determinants, we look at its purely monetary aspects: the wage rate, the unemployment benefit and the length of time one may expect to remain unemployed if fired. A key to this analysis is what income the worker will get if she was fired (the first entry in column B in Figure 6.2). In most countries there are limits on the length of time one can receive unemployment benefits. In all countries, there are limits to how generous one’s family and friends will be in supporting you while you are unemployed. reservation wageWhat an employee would get in alternative employment, or from an unemployment benefit or other support, were he or she not employed in his or her current job.To capture this idea, we assume that the amount of income per week that you will receive if unemployed is some total sum B divided by the number of weeks in your spell of unemployment, i.e. the period that you are out of work, s. The per-week amount B/s divided by the number of hours worked per week (when employed) is called your reservation wage (b), that is, what you can expect to get instead of your hourly wage, while unemployed. In Figure 6.3 we illustrate the case of a worker called Maria who has an hourly wage of W and works h hours, and if she loses her job she can expect to be unemployed for s weeks. We assume this is 10 months (roughly 44 weeks), as was typical among OECD countries in 2016. So every week she loses in income, and her total loss of income occasioned by her spell of unemployment is this number times the number of weeks she will be out of work or This is the shaded area in the figure. We can put some numbers to this area to quantify the size in dollars of Maria’s employment rent. For example, if the hourly wage is $24, hours per week are 35 and the expected spell of unemployment is 44 weeks, then . If we assume that the unemployment benefit is $600 per week and is limited to 30 weeks, then B = $18,000. Hence, the employment rent = $36,960 − $18,000 = $18,960.
John Stuart Mill (1806–1873) was one of the most important philosophers and economists of the nineteenth century. His book, On Liberty (1859),16 parallels Adam Smith’s Wealth of Nations in advocating limits on governmental powers, and is still an influential argument in favour of individual freedom and privacy. Mill thought that the structure of the typical firm was an affront to freedom and individual autonomy. Mill described the relationship between firm owners and workers as an unnatural one:
Attributing the conventional employer–employee relationship to the poor education of the working class, he predicted that the spread of education, and the political empowerment of working people, would change this situation:
6.14 Another kind of business organization: The gig economygig economyAn economy made up of people performing services matched by means of a computer platform with those paying for the service. Workers are paid for each task they complete, and not per hour. They are not legally recognized as employees of the company that owns the platform, and typically receive few benefits from the owners, other than matching.A ‘gig’ for a musician or comedian is a single appearance for which they will be paid not by the hour, but an agreed sum for the performance. The gig economy is not about jokes and tunes, however; it refers to the combined activities of Uber or Lyft drivers, TaskRabbits, Upworkers, Mechanical Turkers, and others who transport people and goods, home-assemble online purchased furniture, and perform other well-defined tasks for which they are paid a fixed rate. Gig workers do their jobs independently, not as members of a team, and gain access to their ‘gigs’ by means of a two-sided digital platform that connects those who will pay for the work, and those who perform it. The gig economy provides an illuminating contrast with the model of labour discipline studied in this unit. The key difference is that there is no labour discipline problem because the tasks performed are sufficiently well defined that a virtually complete contract is possible—if you want to go from your hotel to the airport, your Lyft driver does not get paid until that has happened. If you hire someone to assemble your flat-packed furniture, the TaskRabbit worker who was putting it together does not make any money until it is put together properly.
An important feature of the gig economy is that the only way that workers can get gigs is through the platforms owned by a few firms—for example Uber and Lyft for taxi services, TaskRabbit for tasks around the home, or Mechanical Turk for small administrative jobs. This means that those performing the gigs have no real bargaining power—if a TaskRabbit worker objects to the terms, there will always be another Tasker to do the job. The worker who refused the job will be unlikely to find better gigs on that platform. The digital platform that allows those who need a gig performed to connect to those performing the gigs makes substantial mutual benefits possible by putting together gig workers—who have free time and the skills, a vehicle, or other equipment required—with those willing to pay for a completed gig. But because there are few platforms and many gig workers, they typically receive very little pay for often difficult and onerous work. A result is that gig performers in this economy face extraordinary economic insecurity—they are not guaranteed a fixed schedule of hours and pay, nor do they receive health insurance benefits, maternity leave, holiday pay, or pension contributions through their employer. Why does TaskRabbit, for example, not pay enough for gigs so that the Taskers receive an employment rent, as would be the case in the typical office or plant described by the labour discipline model? The answer is that they do not need to pay more than the gig worker’s next best alternative. They do not need to motivate the worker to do the job—if it is not done, the worker will not be paid. A result is that the gig economy can often produce services at a lower cost and price than are available from conventional firms. The gig economy affects employees in conventional firmsThe gig economy is a small portion even of those high-income economies where, for example, ride services like Uber and Lyft have competed successfully against conventional taxi firms. It has at least three effects on employees working in conventional firms:
6.15 Principals and agents: Interactions under incomplete contractsIn the relationship between Maria and her employer, Maria’s work effort matters to both parties but is not covered by the employment contract. This leads to the existence of employment rents. If they had been able to write a complete contract, the situation would have been quite different. The employer could have offered her an enforceable contract, specifying both the wage and the exact level of effort she should provide, and if these terms were acceptable to her, she would have agreed and worked as required. To maximize profit, the employer would have chosen a contract that was only just acceptable, so Maria would not have earned any rents. This example is not unusual. In practice, all employment relationships are governed by incomplete contracts. Employment contracts often do not even bother to mention that the worker should work hard and well. By contrast, the way we have described the gig economy means that a gig worker does not have an employment contract with a firm. The nature of work in the gig economy is the subject of legal battles in many countries. Why are contracts incomplete?Thinking about some examples of economic interactions, we can see that there are several reasons for the absence of a complete contract:
Principal–agent modelsprincipal–agent relationshipThis is an asymmetrical relationship in which one party (the principal) benefits from some action or attribute of the other party (the agent) about which the principal’s information is not sufficient to enforce in a complete contract. See also: incomplete contract. Also known as: principal–agent problem.In the case of Maria and her employer, the employer is called the principal. The employer would like to offer Maria, the agent, an employment contract and she wants the job, but the amount of effort she will provide cannot be specified in the contract because it is not verifiable. The relationship between the two actors within the firm is an example of a principal–agent relationship. Our model of Maria’s employment is an example of a principal–agent model, in which an action taken by the agent is ‘hidden’ from the principal, or ‘unobservable’.
In short, a hidden action problem occurs when there is a conflict of interest, between a principal and an agent, over some action that may be taken by the agent, and this action cannot be subjected to a complete contract. Incomplete contracts are the rule, not the exception, in the economyUsing the lens of the principal–agent relationship, we can see many other ways in which we interact in the economy and society without a complete contract:
The table in Figure 6.10 identifies the principals and agents in the above examples.
Emile Durkheim (1858–1917), the founder of modern sociology, observed that ‘not everything in the contract is contractual’. There is usually something that matters to at least one of the parties that cannot be written down in an enforceable contract.
Which of the following statements correctly identify who is the principal and who is the agent?
Which of the following are measures that can reduce principal–agent problems?
6.16 ConclusionIn a capitalist economy, the division of labour is coordinated both by markets (which contribute to the decentralization of power) and by firms (which concentrate power in the hands of owners). To understand the role of the firm, we view it not only as an actor in markets, but also a stage on which owners, managers and employees interact in principal–agent relationships. While the separation of ownership and control makes it possible for the objectives of owners and managers to diverge, incentive schemes may help align interests. The problem of hidden actions becomes especially evident in the worker–employer relationship, characterized by incomplete contracts. These arise due to the fact that employees’ effort is neither perfectly observable nor verifiable, and their tasks depend on unforeseeable future events. It is this contractual incompleteness that causes the wages offered to workers to be above their reservation wage, giving rise to an employment rent that incentivizes them to exert effort. Drawing on our game theory and constrained choice tools, we have developed the labour discipline model to study the worker–employer interaction as a sequential, repeated game where the employer offers a wage and the worker responds by choosing the amount of effort she exerts:
The point of tangency represents a Nash equilibrium, and wages set this way are known as efficiency wages. The main implication for the broader economy is that there is always involuntary unemployment in equilibrium. We can analyse the effects of public policies by considering how these affect employment rents and the worker’s best response function. We have also looked at worker-owned cooperatives, where typically less supervision is necessary, and considered the implications of the modern gig economy, including for people currently working as employees in firms. 6.17 Doing Economics: Measuring management practicesIn Section 6.2, we discussed the top-down decision-making structure in most firms, which involves managers directing the activities of their employees to implement the long-term strategies decided by owners. We might expect that firms where employees and production processes are managed well will be more productive than poorly-managed firms. However, defining and quantifying ‘good’ management practices is a challenge. In Doing Economics Empirical Project 6, we look at some ways to measure the quality of a firm’s management practices, and make comparisons across countries, industries, and types of firms, and discuss possible explanations for the patterns we observe. Go to Doing Economics Empirical Project 6 to work on this project.
6.18 References
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