Lazear Shaw 2007 Personnel Economics The Economist S View of Human Resources

Journal of Economic Perspectives—Volume 21, Number 4 —Fall 2007—Pages 91–114
Personnel Economics: The Economist’s

View of Human Resources
Edward P. Lazear and Kathryn L. Shaw
P ersonnel economics drills deeply into the firm to study human resource
management practices like compensation, hiring practices, training, and
teamwork. Many questions are asked: Why should pay vary across workers
within firms—and how “compressed” should pay be within firms? Should firms pay
workers for their performance on the job or for their skills or hours of work? How
are pay and promotions structured across jobs to induce optimal effort from
employees? Why do firms use teams and how are teams used most effectively? How
should all these human resource management practices, from incentive pay to
teamwork, be combined within firms? Personnel economists offer new tools to
analyze these questions—and new answers as well.
In the not-too-distant past, the typical textbook on human resources manage-
ment would often eschew generalization, arguing that each situation is different.
The economist’s approach is the opposite. Rather than thinking of each human
resources event as separate and institutionally driven, economists place a premium
on identifying the underlying general principles, and on using specific institutional
details to identify the causal sources of the general principles. Four primary
building blocks from economics form the foundation of personnel economics:
First, personnel economics assumes that both the worker and the firm are rational
maximizing agents, seeking utility and profits. Of course, the economic approach
y Edward P. Lazear is on leave as Jack Steele Parker Professor of Economics and Human
Resources Management, Graduate School of Business, and Morris A. Cox Senior Fellow,
Hoover Institution, both at Stanford University, Stanford, California. Since February 2006,
he has been Chairman of the President’s Council of Economic Advisers, Washington, D.C.
Kathryn Shaw is Ernest Arbuckle Professor of Economics, Graduate School of Business,
Stanford University, Stanford, California.
92 Journal of Economic Perspectives
allows for constraints or imperfections, such as imperfect information and trans-

action costs, and permits an individual’s utility to be influenced by a variety of
factors such as personal identity, competition, and peer pressure. Second, person-
nel economists assume that labor markets and product markets must reach some
price– quantity equilibrium, which provides discipline for our models. Third, effi-
ciency is a central concept of personnel economics. In the many circumstances in
which inefficiencies arise, the economist pushes the analysis to another level by
asking where equilibrating market forces might have failed, and asking what actions
firms and/or workers might take to reduce the inefficiency. Fourth, personnel
economists emphasize the use of econometrics and experimental design to identify
underlying causal relationships. For example, some firms observe that if the firm
moves to piece rate pay, productivity rises. However, it turns out that piece rate pay
induces the most productive workers to join the firm, as well as changing the
productivity of existing workers.
During the last 25 years, as personnel economics has emerged as a field,
human resources practices have systematically changed. For example, compensa-
tion now varies much more highly across individuals. In 1974, the 90th percentile of
wage earners received about 1.9 times the hourly wage of the 50th percentile, but
this multiple has risen steadily over the last three decades and has now reached
about 2.3. Meanwhile the ratio of the hourly wage paid to the 50th percentile of
wage earners compared to the 10th percentile rose somewhat from about 1.9 in
1974 to 2.1 over the next three decades, but since then has sagged back to a ratio
of about 2.0. In other words, wage inequality has risen markedly mainly because the
upper tail of high earners has grown (Autor, Katz, and Kearney, 2006, forthcom-
ing). This rising variance of pay has occurred within occupations and across
occupations. The variance of pay has also risen within firms and across firms.
The rising variance of pay across individuals surely reflects changing demand
for skills, but also is likely to reflect changes in human resource practices. Com-
pensation has shifted towards pay-for-performance. The proportion of employees’
pay that comes from bonuses rather than from base salary has increased. Table 1A
shows that the share of large firms that have more than 20 percent of their
workforce working with some form of individual incentives, like a performance
bonus, has grown from 38 percent to 67 percent. The percent of firms using any
form of “gain-sharing” or group-based incentives has grown from 26 percent to
53 percent.
Teamwork has become prevalent in many firms. Firms reported pronounced
increases in teamwork since the 1980s, as shown in Table 1B. From 1987 to 1996,
the share of large firms that have more than 20 percent of their workers in
problem-solving teams rose from 37 percent to 66 percent. The percent of large
firms with workers in self-managed work teams rose from 27 percent to 78 percent.
Team use seems to have reached a plateau in the later 1990s, but it’s a high-
level plateau.
Personnel economics is aimed at modeling firms’ use of optimal management
Edward P. Lazear and Kathryn L. Shaw 93
Table 1
Human Resource Management Practices in Large Firms
A: Incentive Pay
% of firms with. . .
individual more than 20% of

incentives, like employees having more than 20% of more than 20% of
performance individual employees having skill-based employees having
bonuses incentives gainsharing gainsharing pay skill-based pay
1987 83 38 26 7 40 15
1990 90 45 39 11 51 17
1993 90 50 42 16 60 23
1996 91 57 45 19 72 22
1999 93 67 53 24 72 26
B: Teamwork
% of firms with. . .
20% or more 20% or more in more than 20%

employees in self-managed self-managed given team-
teams teams teams teams building skills
1987 70 37 27 7 54
1990 86 51 47 10 55
1993 91 65 62 20 75
1996 94 66 78 32 78
1999 84 61 72 28 76
Source: Lawler, Mohrman, and Benson (2001), Lawler, Mohrman, and Ledford (1995).
practices that have contributed to these trends. In what follows, we examine topics
that have become fixtures of personnel economics and attempt to demonstrate
how the notions of maximization, equilibrium, efficiency, and econometric
modeling have enabled economists to further the understanding of human
resources management.
Promotions and Raises
In many large corporations with hierarchical management structures,

wages show discrete jumps between levels of the hierarchy, rather than contin-
uous increases. For example, Jack Welch left General Electric in 2001, when he
earned $4 million in base pay as chief executive officer. He was succeeded by
Jeffrey Immelt, who earned $2.75 million in base pay in his first year as chief
executive officer. But in the previous year, Immelt had been a vice president
earning $1 million (General Electric Corporation, 2001). Why did Immelt’s value
to the company more than double from one day to the next? The annual reports
of public companies are rife with comparable examples in which a job promotion
at the upper executive levels brings a very large salary increase.
In standard human capital theory, wages are determined by skills, and no
conceivable story would allow Immelt’s skills to increase dramatically a few minutes
before he was promoted. Yet this flies in the face of common patterns of managerial
compensation. It appears that jobs themselves—particularly high-level manage-
ment jobs—play a large role in determining the wages of the jobholder. When
Immelt took the top job at General Electric, reports stated that “the Welch protégé
won a valuable prize” and Welch agreed that “He got a hellava raise, I’ll tell you
that” (“GE’s Talent Agency,” Time, December 3, 2000). Analogously standard
notions of competition do not seem to work in this context either. Why didn’t the
other strong candidates for the chief executive officer job offer to work for wages
much lower than those currently being paid to Immelt, bidding down his wage to
close to his previous level?
Something else must be going on. Tournament theory, as it has come to be
called, provides an integrated theory of compensation at different levels of the
hierarchy (Lazear and Rosen, 1981; Green and Stokey, 1983; Nalebuff and Stiglitz,
1983). It addresses how pay raises are associated with promotions and argues that
these compensation levels are not necessarily linked with a naive notion of pro-
ductivity. However, productivity in a broader sense does influence compensation
and is in part determined by it, through an incentive structure. At its heart,
tournament theory makes the point that promotions are a relative gain. Individuals
are promoted not on the basis of their absolute performance, but on the basis of
their relative position in the organization. Furthermore, the compensation at one
level does not necessarily serve to motivate individuals currently working at that
level, but instead motivates all of those below that level who strive to be promoted.
The theory reconciles directly the initial puzzle that individuals are promoted to
jobs and then receive wages associated with those jobs that seem out of line with
their previously recognized skill levels.
Tournament theory begins with the notion that prizes are fixed in advance. In
other words, wages are associated, to a first approximation, with jobs rather than
with the individual who holds the job. A vice president who is promoted to
president receives the salary of a president— even when that salary is considerably
different from the salary previously received. Winning that salary depends on
relative performance. Individuals are promoted not because they are good, but
because they are better than others within the relevant group. Promotion is a
statement about relative position within the firm, not necessarily about absolute
performance. The best worker receives the promotion even if many of the other
workers are excellent.
The larger the pay spread between promotions, the larger the incentive to put
forth effort. Consider a tennis match where winner and loser both receive the same
Personnel Economics: The Economist’s View of Human Resources 95
prize. There is no doubt that individuals generally prefer to win, because pride and
other factors may be involved. But winning becomes more important if the winner’s
prize is significantly larger than the loser’s prize. In tennis, players may practice
harder, forego other competitions, or just focus more on winning when the prize
difference is greater. Similarly, in a corporate hierarchy, a large difference between
the salary of the president and the vice president makes vice presidents more
interested in becoming president, and they put forth considerable effort to get to
that job. Similarly, at lower levels of the hierarchy, newly minted MBAs, lawyers, and
assistant professors work extremely hard so that they can be promoted, or make
partner, or obtain tenure. Accounting firms, law firms, and large corporations all
motivate their managerial employees at least in part by the hope of promotion.
The tournament model also sets limits on the size of pay spreads. Very large
pay spreads induce high effort, but they also create a work environment in the firm
that is not very pleasant. If individuals are working at a very high level of intensity—
say, 80 –90 hours a week—it will be necessary to compensate those employees at a
very high level. At some point, the additional cost to sustain that level of effort will
not be justified by the output. In addition, individuals who are competing with one
another can either seek to outperform others, or they can contribute to the failure
of others. Such incentives can result in collusion (Dye, 1984) or in sabotage
(Lazear, 1989). Thus, pay structure must strike a balance between providing
incentives for effort and reducing the adverse consequences associated with this
kind of industrial politics.
Outsiders can change the nature of internal tournaments. If workers must
compete not only with their coworkers, but also potentially with those employed in
other firms, incentives are diluted. Chan (1996) argues that this is why firms tend
to give preference to insiders over outsiders. Outsiders are hired only when they are
substantially better than insiders. The evidence is that those hired from the outside
move on a faster track than the typical insider at the same position.
Of course, chief executive officers currently receive a significant portion of
their compensation in the form of bonuses or stock and stock options. When Jack
Welch retired as chief executive office of General Electric in 2001, his annual bonus
was $12.5 million. During Immelt’s first year as chief executive officer, his bonus
was $3.5 million. This pattern is consistent with tournament theory because for
chief executive officers who are already at the top rung of the hierarchical ladder,
relative compensation cannot serve as their motivation. Because the output of a
chief executive officer is the profitability of the firm, stock and stock options are a
reasonable metric of their output: in effect, chief executive officers switch from
tournament-like pay to piece rate pay (Rosen, 1986).
Tournament theory has significant empirical support. The structure of wages
within firms and their patterns of promotion are generally consistent with tourna-
ment theory (DeVaro, 2006; Eriksson, 1999). The structure of prizes does seem to
have a direct effect on the level of effort or resources devoted to an activity. For
example, Knoeber and Thurman (1994) show that the size of the spread affects
output in the broiler chicken industry. Ehrenberg and Bognanno (1990) were
among the first to show that effort was responsive to prizes by looking at the scores
that golfers obtained in contests. In experimental work, subjects behave almost
exactly as tournament theory would suggest (Falk and Fehr, 2006). Drago and
Garvey (1998) use a sample of Australian firms to show that when promotion
incentives are strong, individuals put more effort into their jobs (as measured by
absenteeism), but are also less likely to work cooperatively.
For explaining the large discrete jumps in compensation that accompany
major promotions, tournament theory is pretty much the only game in town. It has
stood the test of empirical evidence, it has not been displaced by other theories,
and it is consistent with common sense and standard business vernacular. Indeed,
the competition for the job of chief executive officer at General Electric largely
came down to three individuals: Jeffrey Immelt, Bob Nardelli, and Jim McNerney.
When Immelt got the job, Nardelli went to Home Depot and McNerney to 3M.
When asked later about the competition for the General Electric top job, Bob
Nardelli said “Look, you don’t get to these jobs without being competitive. Any
CEO will harbor that competitive spirit. It’s not against Jeff [Immelt] or Jim
[McNerney]. You want to win. You don’t want to win at their expense, you just want
to win” (USA Today, 2007). This language certainly sounds like someone who
recognizes his own participation in a competitive tournament.
Choice of Compensation Structure and the Hiring and Retention

of Employees
In some firms, most workers are paid a salary. In other firms, bonuses or
performance pay are a big portion of compensation. A survey done by Payscale.com
looked at median salary and bonuses for a sample of occupations in a major
metropolitan area. The median bonus for administrative assistants, social workers,
and nurses is a small percentage of total compensation—less than 2 percent. The
median bonus of a salesperson is $30,000 for nonpharmaceutical sales and almost
$40,000 for pharmaceutical sales. The median salaries of these types of salespersons
are $44,000 and $58,500, respectively, roughly on par with the median registered
nurse’s salary. For salespersons, bonuses make up over 40 percent of total compen-
sation. Pay on the basis of output also extends to much more highly paid jobs, such
as investment bankers, who are paid for the performance of the merger they just
achieved, or hedge fund managers, who are paid for the performance of the fund
they manage. For executive-level positions such as senior vice presidents and chief
executive officers, the portion of compensation paid in bonuses is even larger, and
in fact bonuses often far exceed base salary.
Why do some jobs pay workers an hourly wage or salary and other jobs pay
based on the workers’ performance? Clearly, part of the answer lies in our exam-
Figure 1
Paying for Input versus Paying for Output
(# of people at each wage and output level)
wage 2 ⫽ q ⫺ (measurement costs)

f (q ), f (wage)
q ⫽ output
Output, wage wage 1 ⫽ mean(q )
Note: Without measuring individual output (q), the firm pays wage1 , which is the mean of output across
all workers. After incurring fixed measurement costs, the firm pays all individuals the distribution of
wages labeled wage2. If the firm does not bear these measurement costs, the best workers in area A will
leave the firm for other firms that do measure their individual output.
ples: it is easier, or less costly, to measure the output of salespeople than nurses.
While the cost of measuring output is important in our model, we will tie it to other
key features of employment that build on the concepts of equilibrating markets and
rational decision makers. We will also suggest answers to some important broader
questions: How should firms structure pay for optimal retention of workers? How
should firms avoid losing “star” workers?
Assume that workers in an occupation, such as a portfolio manager at a hedge
fund, have output, q, that varies across workers in the occupation in a typical
bell-curve-shaped distribution shown in Figure 1. Each individual’s output is ini-
tially unknown to the firm, because output is costly to measure. However, the firm
can measure each individual’s output at some cost. The firm has two options. First,
the firm can forego measurement, in which case no measurement cost is incurred
and no information about worker ability is ever revealed. A firm of this sort pays a
straight salary, which must equal the average output. Second, the firm can measure
the output of the employees and pay workers according to their individual output,
which is “pay for performance.” In this case, the distribution of pay matches the
distribution of output, minus the measurement costs.
The question is whether the firm should pay a straight salary—pay all workers
on the basis of input and ignore individual variations in output— or pay on the basis
of measured individual output. Thus, workers will be willing to come to a piece rate
firm if and only if their expected pay in a setting of piece rates with measurement
exceeds their pay in a setting of salary without measurement. The key is for a firm
to choose the human resources practices—pay-for-performance versus salary—

based on the firm’s ability to attract the “right” workers for the firm. This model
provides several important results.
A first implication of this model is that firms will pay for performance when it
is cheaper to measure performance. When measurement costs are low, good
workers will demand that their output be measured. For example, hedge fund
trading is cheap to measure—success is readily quantifiable and relatively near
term—so if one firm pays all traders the same mean wage, the best traders will leave
to work for a firm that does pay for their performance (or will start their own firm).
In Figure 1, the best workers, in area A, will leave the hedge fund firm if the firm
pays an average wage rather than using pay for performance. In contrast, in
commercial banking, it takes years for portfolios to mature, so firms pay average
wages for input, such as hours at the loan desk.1 This model is about self-selection,
or “fit.” Those people who have the skills for hedge fund trading, such as working
under pressure to perform, will gravitate towards this occupation when it does pay
for performance. In contrast, individuals who excel at working with loan customers
will head towards commercial banking. In this case, the firm pays a salary and then
must screen using interviews, experience, and education as signals of talent. Alter-
natively, if the costs of firing are low, firms will hire a range of workers in the full
distribution of Figure 1, then fire for poor performance (Lazear, 1986). Ultimately,
one advantage of pay based on measured output is that individuals who are not well
suited to the required tasks are provided information that allows them to engage in
an alternative activity.
The lower the cost of measuring output, the greater the likelihood that pay is
a function of output. If we look at pay by occupation, we see that pay for output
does rise with our general notion of the ease of measuring output. Empirical
research confirms this: Brown (1990) and Drago and Heywood (1995) show that
piece rates are less common when monitoring costs are higher, a finding in line
with the theoretical prediction. (However, Brown (1992) shows that salaried work-
ers whose salaries are tied to supervisor ratings, do not earn more than their
unsupervised colleagues, in contrast to the theoretical prediction.) We would also
expect that, if the cost of measuring output is decreasing over time— due to
information technologies, for example—then more firms should pay for perfor-
mance. Anecdotal evidence suggests that these patterns hold true, although more
systematic analysis remains to be done (Andersson, Freedman, Haltiwanger, Lane,
and Shaw, 2006).
A second implication of this model is that firms are more likely to pay for
performance as the worker’s alternative wage offers approach the value at the
1
There are other dimensions of output, such as client relations and business development. Sometimes,
compensation schemes build in bonuses for superior performance along these dimensions. Further-
more, revenue is not profit, so incentives are sometimes made product-specific to prevent salespeople
from selling high-price, low-margin goods.
current firm. When a worker has alternative high-paying jobs, it is important for the
firm to pay the worker for what they produce or the firm will lose the worker. One
example is job-hopping in Silicon Valley (Fallick, Fleischman, and Rebitzer, forth-
coming). In the earlier years, computer programming skills would often be firm-
specific (as for Oracle or Microsoft). As Silicon Valley developed, and markets
thickened, many firms could now make use of what were once firm-specific skills,
and mobility rose. More mobility is consistent with fewer firm-specific skills. It also
implies that wages should be more variable across workers in the new environment.
This insight has implications for attracting and retaining workers. Workers
with firm-specific human capital will find that current productivity is likely to be
much greater than their alternative productivity in another job, and so they are less
likely to be paid on the basis of output. Being paid for individual performance is
also more likely to occur when a worker is young, before a great deal of specific
human capital is acquired. Thus, the best time to sort workers is when they are
young. As a corollary, senior people in the firm are less likely to be measured.
Tenure reviews and decisions to promote to partner take place early in careers for
this reason.
Third, as the lower tail in the distribution of worker quality like Figure 1 gets
larger, performance pay is more likely to be optimal. A larger lower tail means that
the value of weeding out low quality workers rises.
Thus far, we have emphasized how the choice between pay for performance
and salary leads to selection and sorting among workers. Conversely, we have
ignored the possibility that paying for performance can induce people to work
harder. Naturally, economists have also emphasized that some people are likely to
work harder when there are tangible rewards. Workers with a high disutility of
effort relative to their output will avoid firms that pay for performance. Workers are
heterogeneous—those who value intrinsic internal motivation more than extrinsic
rewards will gravitate towards jobs with salary or wage-based pay: not everyone
would enjoy the risk and rewards and work environment of being a hedge fund
manager. This feature could be added to the model above, and it would introduce
additional issues that we will not expand upon here. Nonetheless, we can look in
the data to see if pay-for-performance raises output.
The likelihood that pay-for-performance will encourage more effort raises
some questions about identifying causal relationships carefully. For example, hedge
fund managers earn more than do commercial bankers. Since hedge fund man-
agers have a larger portion of income paid in incentive pay, an unwary human
resources person might conclude that paying for output makes workers more
productive. However, putting in place an output-based pay plan for commercial
bankers might well provide only very limited results.
Why might this be the case? First, it takes time for those who are best at selling
loans to switch to those jobs. Thus, productivity gains from moving to a commission-
based system for loan officers may be smaller in the short run than in the long run.
Second, measuring the performance of commercial bankers may prove tricky. For
example, a bank that sets pay based on the number of loans may find that the rate
of loan defaults increases. If a number of those defaults happen only several years
into the future, the commercial bank may find itself better off just paying salary.
Third, loan officers may never be as productive as investment bankers, because
successful investment bankers produce a higher dollar value-added (or productiv-
ity) per unit of effort than do commercial bankers. In keeping with the higher
productivity of investment banking, the firm must hire more highly talented people
as investment bankers, and pay them more. If a human resources manager does not
consider such selection effects, the gains from implementing an incentive pay
program may be much lower than expected.
What do the data tell us? Performance pay is used to induce selection by
workers into the right jobs. For example, Lazear (2000) provides an example of
a firm that installs windshields: individual workers drive their trucks to custom-
ers with damaged windshields and install new windshields. When the firm
switches from hourly pay to piece rate pay, the average daily productivity goes
from two windshields to three. Some of the increase would be due to the
rewards for performance. About half probably comes from selecting workers
who can respond to those incentives (by exerting more effort) and about half
from selecting workers who can respond to those incentives with high effort or
talent.
Numerous other studies find performance gains and selection effects from
performance pay. Other evidence exists on how workers respond when presented
with varying compensation schemes. Asch (1990) presents evidence that Navy
recruiters vary their recruitment effort in response to incentives. Using data on
jockeys, Fernie and Metcalf (1999) show that incentive contracts generate superior
performance to other, noncontingent payment systems. Using an experiment in a
tree-planting firm, Shearer (2004) shows a productivity gain of around 20 percent
when worker compensation was switched from a fixed wage to a piece rate system.
Freeman and Kleiner (2005) do find that productivity falls when switching from
piece rates to salary pay, but profitability rises because performance pay under-
mines other goals, such as lowering inventories. Similarly, Lo, Ghosh, and Lafon-
taine (2006) show that salesmen of industrial products are offered contracts with
piece rate pay in part to increase personal performance and in part to induce the
selection of salespeople who respond well to that type of contract. In a survey of
firms across industries, Parent (1999) documents the existence of an incentive
effect whereby men who are paid a piece rate are induced to work harder/more
efficiently.
Thus, personnel economics provides implications for the structure of pay
across occupations and experience levels. The choice between pay-for-performance
and salary is determined by concerns of economic efficiency in different employ-
ment settings, including the level of measurement costs and the value of screening
out workers to specific employers.
Pay Compression
Another element of the choice of compensation is whether, within a firm, the

firm’s pattern of pay for individuals should have less variance than does individual
performance. No systematic data exists on individual output, so no one knows
whether pay is generally more compressed than output within firms.2 Nevertheless,
managers and human resource professionals within firms do have a sense that pay
is more compressed than output, and often ask the question, how compressed
should pay be?
The often-stated objective of a more compressed pay structure is to make pay
more equitable. People do seem to value equity or fairness in pay (Baron and
Kreps, 1999). However, fairness is a slippery concept. Is it fair to pay all workers the
same amount, or does fairness require that workers are paid in proportion to their
output? What if output results from inherent differences in ability rather than
choice about effort? If endowed ability is viewed as luck, should firms ignore these
differences? If some firms did ignore differences in innate ability, what would
happen in a competitive market where other firms that do pay on the basis of ability
attract the most able workers and thereby lower costs relative to the compressed
wage firms?
There are a number of reasons to believe that some degree of pay compression
is an efficient market outcome. For example, perhaps a greater degree of equity or
fairness produces higher productivity, perhaps through greater teamwork. This
trade-off will vary across firms. For example, in firms with more team-based work,
pay should be more compressed for numerous reasons: equity is more relevant in
close comparisons, and individual output that would attract an outside wage offer
is more difficult to disentangle from group results.
In the tournaments model above, workers may distinguish themselves not only
by making themselves look good, but also by making their rivals look bad. When pay
or other forms of rewards are based on relative performance, cooperation is
discouraged as workers try to outshine their competition. To reduce the incentives
to undermine coworkers, pay compression becomes part of optimal contracts. In
general, pay compression reduces the incentives to engage in sabotage or other
noncooperative behavior that is induced by the prisoner’s-dilemma-style payoff
structure (Lazear, 1989).
A related idea involves pay compression that results because workers try to
influence their superiors (Milgrom, 1988; Prendergast, 1993). As the gains from
2
The evidence on this is sketchy because pay and productivity are rarely measured in the same data set.
The theory and popular literature on this are somewhat schizophrenic. In one paper, Frank (1985)
argues that pay is compressed relative to productivity. Years later, Frank (1996) argues that pay is spread
out too much because of the winner-take-all nature of pay in some occupations. In one dataset that has
productivity and wage data, the variance in productivity is smaller than the variance in pay (Lazear,
1999b).
appearing better than another in the firm increase, the incentives to lobby one’s
boss become greater. Pay compression serves to mitigate these effects.
Finally, pay may be compressed because it is efficient to have the firm insure
workers against uncertain outcomes, like bad luck on the job or bad luck when sales
fall due to market conditions. One difficulty with this kind of insurance is that it is
subject to severe moral hazard problems. If workers know that they will be insured
against low productivity outcomes, incentives to put forth effort are reduced.
It is difficult to test whether firms are compressing pay relative to output. If
some firms compress pay, high-ability workers should leave those firms. Eventually,
firms with compressed pay will be comprised entirely of “average” or below-average
workers. In Lazear and Shaw (forthcoming), we don’t find that that mobility rates
are higher for high-wage people in firms with more compressed pay. But again, the
data we have does not measure ability, so firms with compressed pay may already
lack high-ability workers.
Hedonic Wage Analysis and Nonmonetary Job Attributes
Money isn’t everything. Employees care about more than pay. When asked,
employees state that they care about flexible hours of work, comfortable working
conditions, colleagues whom they enjoy, projects on which they enjoy working, and
bosses who provide recognition and mentoring. Employees also care about the
nonwage benefits, such as health insurance and pensions. However, preferences for
these benefits vary across workers: older workers are more likely to care about
pension benefits or high-quality health insurance than younger ones. The question
is, should the firm offer more pensions, or more health insurance, or flexible
hours? How do benefits affect the amount of base pay offered? The hedonic model
of compensation provides a structure for firms to use in answering these questions.
Benefits are often costly. This fact is obvious in the case of pensions and health
insurance, but even nonmonetary benefits, such as flexible work hours, can
increase coordination costs for the firm. These benefits can also have productivity-
enhancing effects: for example, pensions may cause productivity to rise as workers
invest in more human capital and have a longer time horizon at the firm (Lazear,
1979), or flexibility may increase productivity as workers choose when best to work.
However, the hedonic model tends to focus on the cost side of benefits, or at
least to assume that productivity enhancements from benefits do not totally out-
weigh the costs. In this setting, a trade-off arises—if the firm offers more benefits,
it must offer less pay. How should a firm strike the right balance between wages
and benefits?
The key insight of the hedonic model is that a firm should offer the package
of pay and benefits that will attract the workers it desires. The interaction between
workers’ preferences, the firm’s cost structure, and the firm’s desire to attract
employees will determine how many benefits to offer.
The first and perhaps most obvious prediction of the hedonic model is that
there is a negative trade-off between wages and “positive” job attributes, attributes
like status or flexibility in hours of work.
A second key prediction of the hedonic model is that each firm offers the
benefits that will attract the types of workers that the firm values the most. Consider
an example from the software industry. SAS is a firm that produces statistical
software licensed to big corporations, and their product’s value comes from its very
high re-licensing rate from its existing customers. Therefore, SAS wants software
programmers who serve customers well by designing product upgrades that suit
customer needs. To attract such programmers, SAS offers pension benefits and
other family-friendly benefits. In contrast, the typical firm in Silicon Valley is less
likely to provide pension benefits. These other software firms value software pro-
grammers who are younger and have the latest programming skills in new tech-
nologies. In turn, these young workers prefer high pay (and risky stock options)
and state-of-the art programming projects over pensions.
A market equilibrium sorts workers to their optimal match or “fit” with firms.
The firms that value loyalty among workers, like SAS, will offer pension benefits,
and the workers who want stable long-term jobs will choose these firms and will give
up some base salary to get the pension. The firms that value the skills of a young
mobile workforce will not offer pensions, and the young workers will choose the
high pay and stock options of these firms. The model tells us both how much the
firm should offer in benefits and why they should offer particular benefits to attract
certain types of workers.
Does the data support these two predictions of the model? At first glance, the
data does not support the prediction that wages and benefits are negatively corre-
lated. In fact, if we look at typical job attributes, such as pensions, health insurance,
or safe working conditions, there is a positive correlation between these benefits
and pay. As shown in Table 2, the percentage of individuals covered by employ-
ment-based health insurance rises with family income. However, simple correla-
tions are not a fair test of the hedonic model. Simple correlations always produce
an upward bias (or positive trade-off) because in the cross-sectional sample under-
lying these correlations a person’s ability is not observed. People of higher ability
will get both higher base pay and higher benefits than people of lower ability. A
college-educated worker typically has both higher pay and benefits than a high-
school educated worker, so as base pay rises, benefits rise. Since worker ability
differences cannot be measured solely by education, cross-sectional regressions
always suffer from an omitted ability bias that produces the positive pay– benefit
correlation.
As a thought exercise, consider the sort of data needed to test for a negative
trade-off between benefits and pay. Collect data on one person’s job offers after
they have gone to a broad range of firms that offer different pay packages, and see
if a negative trade-off exists in their job offers. The closest we can come to this
thought experiment is to follow individuals over time as they change jobs and see
Table 2
Percentage of Individuals Covered by Employment-Based Health Insurance
(by family income)
Covered by employment-based As a percent

Family income Total health care of total
Whites
All Whites 240,909 147,367 0.61
⬍$25,000 52,424 11,996 0.23
$25,000–$49,000 59,753 32,561 0.54
$50,000–$74,999 46,360 34,111 0.74
$75,000 or more 82,372 68,699 0.83
Blacks
All Blacks 36,965 18,003 0.49
⬍$25,000 14,578 3,156 0.22
$25,000–$49,000 9,944 5,483 0.55
$50,000–$74,999 5,844 4,042 0.69
$75,000 or more 6,599 5,322 0.81
Source: U.S. Census Bureau, Current Population Survey, 2006, Annual Social and Economic Supplement.
if there is a negative trade-off in pay packages. Studies of this type do find a small
negative trade-off (Brown, 1980). However, this approach does not fully solve the
selection problem: after all, individuals do not choose their new jobs randomly. The
average software programmer in Silicon Valley who knows his pay– benefits prefer-
ences will not move to SAS; thus, we never estimate the true trade-off. Of course,
that is the point of the model: benefits are used to cause workers to select the firm
that values them the most.
This point leads to the test of our second prediction: do firms use benefits to
encourage workers to sort to the firm that values them the most? The evidence
shows workers sorting to firms based on benefits. Oyer (forthcoming) shows that
workers match to the firms that offer the benefits each worker values. Stern (2004)
looks at the pay of scientists and finds support for both predictions of the model.
High-quality scientists often take cuts in pay in order to work on good projects, and
firms offer them the projects and pay packages they desire.
After the basic theory of the hedonic model was developed by Rosen (1974; see
also Thaler and Rosen, 1976), empirical methods essential for addressing selection
issues evolved, allowing for new tests of the model. Methods for thinking experi-
mentally using nonexperimental data improved our understanding of the hedonic
model itself as well as the tests of it (Epple, 1987).
Viewing seeming nonmonetary attributes of the job as having trade-offs that
can be monetized is a major breakthrough, because it means that any model in
personnel economics can be applied to nonmonetary rewards just as well as to
monetary incentives. For example, the tournaments model above, which dis-
cusses motivation in terms of prizes that take the form of higher salaries, can
also be interpreted to refer to prizes that take the form of status or prestige, not
money.
Hedonic analysis as done by economists is very different from approaches
taken by other human resources scholars. The hedonic notion that everything can
be monetized is anathema to the approach taken by industrial psychologists.
Instead, those fields tend not to think in terms of trade-offs, but in terms of status
or identity associated with positions (March, 1999). In these status or identity
models, an individual may demand a particular feature of a job because it is
consistent with his identity. Economists certainly introduce concepts of identity as
well, but identity is added to an equilibrium model of rational decision making (see
the next subsection on teams below).
Personnel economists explicitly think in terms of substitution and trade-offs,
and firms have begun to do so as well. For example, for many years, most firms have
had a benefits department that is distinct from the compensation department.
Firms had thought in terms of providing some market level of each job attribute,
rather than thinking in terms of a total package of utility for pay and for benefits.
As firms have moved towards an emphasis on human resources as a strategic
decision, these trade-offs are increasingly recognized. Simple evidence of this
change is that workers are now given choices: flex benefits plans allow them to
purchase different amounts of health care versus pay. The hedonic model also tells
us that employees will not be offered the full range of choices. If the firm feels it
has the right range of pension–pay packages to attract the workers it desires, it will
not give workers additional choices.
In the personnel economics model, the provision of benefits and nonmonetary
job attributes has little to do with identity or other external factors; instead, it is
motivated by rational behavior and efficiency as firms seek out the kinds of workers
they desire.
Team Production
Teamwork has increasingly become a way of life in many firms. From 1987 to
1996, for example, the share of large firms that have more than 20 percent of their
workers in problem-solving teams rose from 37 percent to 66 percent, as shown
earlier in Table 1. The percent of large firms with workers in self-managed work
teams rose from 27 percent to 78 percent. Team use seems to have hit a plateau in
the 1990s; but it’s a high plateau.
Why do so many workplaces now use teams? Teams can be time consuming to
organize and coordinate, and the apparent slow progress of teams is nearly pro-
verbial. Moreover, managers and team members always worry about the free-rider
problem—that indolent individuals will free-ride on the effort of a few team
members. So why do firms use teams? How should teams be managed? And what
types of firms are likely to gain the most from teams?
One reason firms use teams is that team production can be more productive
than individuals working alone. For example, suppose that the goal is to develop a
new product. How should workers be organized to achieve this objective? In Figure
2, two different situations are depicted. Suppose that two skills, design and opera-
tions, are needed to produce a product. A point in the space reflects the amount
of knowledge that an individual has in each of the two required skills.
In Figure 2A (the left-hand panel), individual 2 is strong on operation skills,
but relatively weak on design skills. Individual 3 is strong on design, but weak on
operations. If person 2 needs to think about design, person 3 is a good person to
ask. If person 3 needs to think about operations, then person 2 is a good person to
ask. If skills are distributed as in the left-hand panel, then team communication
seems best because each person has an absolute advantage in one of the two skills.
With teams, it is as if each member has access the good operations skills of
person 2 and the good design skills of person 3, rather than only their own
individual endowment of these skills. Note also that individual 1 has no area of
greatest expertise, but may be sufficiently cheap to make hiring this person
worthwhile.
Suppose instead that the situation is that shown in Figure 2B. Now, person 4
has an absolute advantage in both design and operations. If person 2 has a question
about design, person 4 is a better resource than person 3. If person 3 has a question
about operations, person 4 is a better resource than person 2. This setting is
better-suited to a hierarchical organization, where person 4 is the supervisor to
whom all go to consult.
When does the firm choose the Team versus Hierarchy? If individuals like type
4, who possess an absolute advantage in both skills, are more expensive because
they are rare, firms will choose teams. Which firm types are likely to be willing to
pay for the one-dimensional experts shown in the left-hand panel? Maybe new
technologies would more likely be associated with firms consisting of teams of
experts, because in new technologies, rapid evolution of information makes it
difficult for any one person to have an absolute advantage in everything. As
technologies mature, very talented individuals may, over time, acquire knowledge
in a multitude of skills, making a hierarchical structure more natural. It is also true
that new technologies are associated with firms that introduce teamwork (Bartel,
Ichniowski, and Shaw, forthcoming; Bloom and Van Reenen, 2007).
The model of teamwork introduces the importance of complementarity
between the skills of different workers. When the design expert works with the
operations expert, they produce a new product design that is better than the two
individuals could have produced working independently. In other words, workers’
inputs interact multiplicatively, so that each worker’s marginal product is enhanced
by combining effort with another worker who has different skills.
The figure emphasizes several features of team interaction that may be central
to creating value in teamwork: Lazear (1999a) provides more detail. The first
feature, which is especially clear in Figure2A, is “disjointness:” that is, the gains
Figure 2
When to Use Teams
A: Team of Experts B: Hierarchy of Generalists

4
skill D3
Design skills
Design skills
3 3
skill D2 skill D2
1 2 1 2
skill D1 skill D1
skill 01 skill 02 skill 01 skill 02 skill 03

Operations skills Operations skills
from team interaction are greater when individuals have different skills or different
information. The second feature is relevance: that is, the skills of team members
should not only be nonoverlapping, but also relevant. Third, teamwork requires
communication, which can involve both common jargon and personal knowledge
of each other. Communication costs are likely reduced over time as individuals
learn to speak each others’ languages.
Fourth, firms that need to solve complex problems quickly should use teams;
firms that need to check decisions should be more hierarchical. Consider an
example. Coke has invested heavily in its brand value and the shape of its tradi-
tional bottle. Any design alteration by a product design team should be checked
very carefully, by many bosses up the hierarchy, before any new design could be
launched. The example illustrates that team-based decision making is too costly
when the bad decisions of team members can have very negative consequences for
the firm. A generalist, such as person 4, will typically cost more than individual
experts. Generalists, who can check the designs of experts, should be hired as well
when the value to the firm is high. In contrast, a new firm, with no brand value, can
risk letting the team of experts decide, because the risk of making a poor decision
is less costly to the firm.
A variety of empirical evidence shows that teamwork can be more productive,
for reasons based in the sources of productivity described above. The model of
worker complementarity within teams is supported in Hamilton, Nickerson, and
Owan (2003), which found that adoption of teams in a garment factory increased
productivity on average by 14 percent and that more heterogeneous teams were
more productive than teams of the same ability. Communication is also very
important in teams. In a study of 700 workers in steel mills, workers in the mills with
a team-based environment reported much higher levels of communication with all
peers and supervisors than in the hierarchical mills (Ichniowski and Shaw, 2003).
Given the increased communication required for teamwork, teams are more pro-
ductive when communication costs are low. The firms that use teams the most are
those that have complex problems to solve. For example, in a study of steel
production, Boning, Ichniowski, and Shaw (forthcoming) show that team systems
produce the greatest gains and are more likely to be adopted in steel mills that have
complicated problems to solve because their products are complex.
The economic approach to team configuration is motivated primarily by an
emphasis on complementarity of skills. Although other disciplines have loosely
defined notions of complementary skills, the rigorous definitions of absolute and
comparative advantage in economics provide specific implications. For example, it
is not sufficient that one member has absolute advantage in a certain skill. It is
necessary to understand the equilibrium wage differentials across individuals of
different types to know whether one form of organization like hierarchy dominates
another form like team production.
The U.S. economy has seen pronounced changes in the pricing of skills
coinciding with the rise of teamwork. Since 1987, as discussed earlier, wage inequal-
ity has risen markedly, specifically the gap between the pay of workers at the 90th
percentile of the wage distribution and the median worker has grown yearly (Autor,
Katz, and Kearney, 2006). In short, the wages of highly skilled “star” workers have
grown relative to the typical employee (Andersson, Freedman, Haltiwanger, Lane
and Shaw, 2006). Are these stars experts, like persons 2 and 3 in Figure 2, or
generalists, like person 4? Perhaps both. Experts are highly valued: the inequality
of wages has risen within very narrowly defined occupations. General skills are also
valued: the underlying skill that is rising in demand (and pay) is “cognitive
nonroutine problem solving skills” across all occupations (Autor, Levy, and Mur-
nane, 2003). We do not have national data that combines information on firms’ use
of teams and the skills and wages of their employees. The data does suggest that
firms are increasingly comprised of problem-solving experts, and firms are increas-
ingly team-based.
The Complementarity of Human Resource Management Practices

and Organizational Transformation
Firms are changing their human resources practices toward more incentive pay
and more teamwork. Yet some managers report that their experiments with new
practices have failed (for examples in the steel industry, see Ichniowski, Shaw, and
Prennushi, 1997). Are there general principles that managers can follow that are
more likely to produce successful results when they implement these practices?
When a new practice is introduced, it often requires supporting practices to be
successful. For example, teams are more productive when workers are better
trained, or are given team-based incentive pay, or are selected carefully for skills
that are complementary. If the firm does not introduce all practices, the teams may
well fail to produce higher output. Human resources practices can be comple-
ments, in the sense that doing more of one of them increases the returns to doing
more of the others. Economists and noneconomists both emphasize the value of
complementary practices (for example, Baron and Kreps, 1999; Pfeffer, 1994).
Thus, when firms consider alternative human resource management practices,
such as teamwork or incentive pay, they would be wise to consider the value of the
collective set of practices rather than the value of individual practices.
Empirical evidence supports the claim that greater value can be obtained from
introducing a set of complementary practices than from introducing individual
human resources practices. Ichniowski, Shaw, and Prennushi (1997) gather data
from four systems of human resource practices that are used in 35 steel mills. The
mills that introduce a complete system of innovative practices—such as group-based
incentive pay, teamwork, careful hiring, high communications with workers,
implicit job security, extensive training, and job flexibility—are substantially more
productive than the mills that introduce a very limited set of teams.
Many other examples of the importance of complementary practices prevail
(Roberts, 2004). Southwest Airlines uses a set of labor practices that focus on
teamwork, training, and careful hiring that seem to result in a set of satisfied
customers and fast turnaround time for planes. When traditional airlines attempt
to compete with Southwest and fail, it is most likely because large airlines cannot
introduce the entire set of practices that would mimic Southwest (O’Reilly, 1995).
Because human resources practices form complementary sets, in optimizing
production, the choices firms have before them look like a mountain range—there
are local peaks in output with valleys between them. In a traditional production
function, firms increase labor to move up the peak towards the highest output, then
hit diminishing returns to labor and slide down the side of the mountain. Instead
of choosing amounts of labor, firms are choosing sets of complementary labor
practices (Roberts, 2004). One peak in output arises when the firm chooses the
complementary set of traditional labor practices: close monitoring of workers, little
problem-solving, and workers doing their jobs alone. If the firm then introduces
teams, output may fall, as this takes time away from production but does not raise
output. The firm enters a valley, and does not get to another, perhaps higher, peak
until it combines the entire set of practices that support teams. In the real world
with adjustment costs, firms can’t always make leaps from peak to peak, and may get
trapped in a valley in the short run. Therefore, when firms change their human
resource practices, they must know their ultimate goal and take the risk of a
short-term fall in output. Moreover, individual managers cannot be given the power
to make marginal changes in human resources practices.
Returning to the evidence from the steel industry, Ichniowski and Shaw (1995)
show that steel mills rarely make big leaps to highly innovative practices, despite the
evidence that the sets of innovative practices are ultimately successful. More
broadly, Baron and Hannan (2002) follow about 200 start-up companies as they
choose their human resources practices and change their practices over time.
The evidence showing that firms form sets of complementary practices is strong
and furthermore confirms that firms have difficulty leaping between these sets
(Roberts, 2004).
Conclusion
For most of the last century, personnel, later called human resources manage-
ment, was the territory of industrial psychologists and those who studied organiza-
tional behavior. But in the 1970s, economists began to bring the formalism and
rigor of economic thinking to human resources. The model for personnel eco-
nomics, the field that grew out of that endeavor, was modern finance. Finance was
historically an institutional field without much theoretical or even empirical un-
derpinning until the modern developments of scholars like Merton Miller, Harry
Markowitz, William Sharpe, Eugene Fama, Fischer Black, Myron Scholes, Robert
Merton, and many others who followed in their footsteps. These scholars trans-
formed the field of finance into a branch of economics in large part by recognizing
that a few basic principles, such as arbitrage, governed financial markets. Personnel
economics has followed a similar path and is beginning to gain the prominence
that modern finance has enjoyed.
What does personnel economics add to traditional methods of studying
human resources management? Most labor economists who taught in business
schools have traditionally encountered a disinterested audience. Traditional topics
of labor supply and demand, unemployment, and investment in education, which
are of primary concern to labor economists, are almost irrelevant to their business
students. The issues studied by human resources specialists were of interest to
economists, but the approach taken by the noneconomists lacked the formal
framework to which economists have grown accustomed. The entry of economists
into the field of human resources management was assisted by breakthroughs in
agency and contract theory, which enabled economists to tackle problems that had
evaded them in the past. Entry was further assisted by advancements in economet-
rics, including ways of addressing sample selection bias, omitted variable bias, and
endogeneity, as well as by the use of panel data, which allowed economists to
formulate and test models in a way that closely approximated experiments in the
use of alternative human resource management practices.
In providing guidance to firms in the choice of their human resource man-
agement practices, several themes have emerged. Many of the models emphasize
the importance of “fit.” Firms and workers achieve fit when a worker’s skill set,
broadly understood, is matched to the firm that values it the most. Workers, or
potential employees, have very heterogeneous skills and preferences. Because
measuring the output of individual workers is often difficult, it becomes especially
important to think about the incentives workers face. Pay for performance may not
just induce the higher effort levels, but may also induce workers to select the firm
that is the best fit for their skills, effort, and tastes. Personnel economics emphasizes
the importance of human resources practices for inducing workers’ self-sorting

to firms.
Better fit or performance is achieved when complementary people are
matched to each other within the firm, or when complementary human resources
practices are matched to each other. People are complements when the skills of
one enhance those of another within their team. Human resources practices are
complements when one practice—such as teamwork—is combined with another
practice—such as group-based incentive pay—such that together they raise output
more than would either practice independently.
Alfred Marshall’s ([1890] 1961) famous statement that it is not the economist’s
business to tell the brewer how to brew beer has not been adhered to when it comes
to personnel economics. Personnel economists, at least in their interactions with
business students and practitioners, are attempting to use the tools of economics to
understand, and even sometimes to guide, practices.
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Lazear Shaw 2007 Personnel Economics The Economist S View of Human Resources

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Journal of Economic Perspectives—Volume 21, Number 4 —Fall 2007—Pages 91–114

Personnel Economics: The Economist’s

Edward P. Lazear and Kathryn L. Shaw

allows for constraints or imperfections, such as imperfect information and trans-

individual more than 20% of

20% or more 20% or more in more than 20%

Promotions and Raises

In many large corporations with hierarchical management structures,

Choice of Compensation Structure and the Hiring and Retention

wage 2 ⫽ q ⫺ (measurement costs)

Output, wage wage 1 ⫽ mean(q )

to choose the human resources practices—pay-for-performance versus salary—

Another element of the choice of compensation is whether, within a firm, the

Hedonic Wage Analysis and Nonmonetary Job Attributes

Covered by employment-based As a percent

A: Team of Experts B: Hierarchy of Generalists

skill 01 skill 02 skill 01 skill 02 skill 03

The Complementarity of Human Resource Management Practices

the importance of human resources practices for inducing workers’ self-sorting

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