UNIT-6.

COMPENSATION
It is not the employer who pays the wages. Employers only handle the money. It is the customer
who pays the wages. Henry Ford

1. Compensation
The employment relationship is an economic transaction between an employer and an employee. In
this relationship, the employee needs the employer as much as the employer needs the employee.
The employee contributes with their work, effort, time, dedication, and human capital and receives a
compensation (cash and noncash compensation) from the employer in exchange. Compensation is
one of the most critical and complex decisions employers make. Such complexity explains why
each industry, each occupation, each country has its own specific compensation characteristics.
UNIT-6 and UNIT-7 aim to provide a general but realistic description of compensation by combining
real information on how employers actually compensate their employees with a more abstract view
of compensation from theories in economics.

Equations (19) and (20) show the components of compensation,

TOTAL COMPENSATION = CASH AND NONCASH COMPENSATION (19)

CASH COMPENSATION = WAGE AND SALARY + BENEFITS (20)

Figure 13 shows WAGE AND SALARY defined as regular payments from employer to employee as
compensation for services performed during a specific period of time or based on production,
sales, or specific output.

Figure 13. Wage and salary (Source: BLS)

Figure 14 shows BENEFITS or add-on to WAGE AND SALARY.

Figure 14. Benefits (Source: BLS)

Total or overall compensation also includes noncash compensation such as health care on-site,
work from home, reduced or flexible hours, unpaid extended leave, sabbatical, volunteer time off,
company social events, legal assistance, on-the-job training, or professional development. The
importance of noncash compensation elements as well as the variety of noncash compensation
elements are growing.
2. Perfectly competitive labor market

Figure 15 presents the traditional diagram of a perfectly competitive labor market consisting of
firms and workers.

Firms demand labor. Each firm must decide how many and which types of workers to hire and fire,
the lenght of the workweek, how to compensate them (including cash and noncash compensation),
the type of working conditions, and how much capital to invest in. Each of these decisions is driven
by the desire to maximize profits. Adding up the demand for labor of millions of employers
generates the economy's labor demand. The labor demand slopes downward showing the
relationship between the quantity of labor employed and the marginal returns to that labor. This, in
turn, reflects the assumption of a constant price and the part of a production function in which,
holding capital and technology fixed, the marginal product of labor is positive but decreasing.

Workers, on the other hand, supply labor. They decide whether to work or not, how many hours to
work, how hard to work, which skills to acquire, when to quit a job, which occupations to enter, and
whether to join a labor union. Same as for firms, workers' decisions are driven by the desire to
optimize. Workers make decisions that maximize their well-being. Adding up the decisions of
millions of workers generates the economy's labor supply in terms of the number of persons
seeking work, and also in terms of the quantity and quality of skills available to employers. Persons
who want to maximize their well-being tend to supply more time and more effort to those activities
that provide a higher cash compensation, shown in the vertical axis of Figure 15. The labor supply
curve, therefore, slopes upward, reflecting differences in workers' reservation wages. The
RESERVATION WAGE is the lowest wage rate at which an individual is willing to accept a particular
job or work opportunity. The reservation wage includes all cash compensation elements shown in
Figure 13 and in Figure 14.
 RESERVATION WAGE = CASH COMPENSATION (21)

So workers prefer to work when the wage is high, but firms prefer to hire when the wage is low. If
markets are competitive and if firms and workers are free to enter and leave these markets, a freely
set wage will equilibrate supply and demand, by making the reservation wage of the last worker
hired equal to the revenues he or she adds to the firms.

Figure 15. Equilibrium in a competitive labor market

3. Efficiency wage theory
According to the efficiency wage theory, compensation must be perceived by employees as FCAE:

Fair
Competitive in the market
Accurately based
Easy to understand

Perceptions of fairness are based on comparisons. Employees compare the ratio between how
much they get (compensation) and how much they give (effort, time, human capital) with co-
workers in their firm (internal pay-comparisons) and with workers in other firms (external pay-
comparisons). In general, perceptions of inequality or unfairness tend to reduce workers'
motivation. Workers who perceive their compensation is worse than the compensation of
coworkers might decide to work less hard, or refuse to cooperate with their peers. On the other
hand, workers who perceive they are receiving less than other workers in similar jobs but in other
companies might decide to leave the company.

Figure 16 suggests how to design an efficient compensation structure as part of High-Performance

HRM.

Figure 16. Characteristics of an efficient compensation structure

Setting a pay range or pay interval with a minimum and a maximun level of pay instead of just one
level of pay for each job gives the employer more flexibility to:

Attract and retain talent (the job offer provides the new hire a minimum and a maximum
instead of just a value and there is room for growth, since the worker's compensation can get
better off up to the maximum level of pay)
Extrinsically motivate workers (by using incentives or pay for performance)

Expression in (22) shows an efficient compensation structure designed according to Figure 16,
J J J
[w ,w + c ] (22)
M M

The compensation structure in (22) is a pay range, where the lowest value is the market wage for
job J (the wage that equilibrates supply and demand). wL
M
is a reservation wage and includes all
cash compensation. The highest value of the pay range is the market wage plus the contribution of
the job to the firm value, cJ .

Figure 17 shows pay ranges for Lawyers (SOC 23-1011) and for General and Operations Managers
(SOC 11-1021) calculated according to (22).

Figure 17. Efficient compensation structure