ECO 610-401

Monday, November 17th

– Organizational Design: Centralized vs. Decentralized
– Internal Labor Markets
– Exam Review
• Review Sheet
– Readings, Brickley et al., 12, 14
– Extend Assignment #2 Due
• Solutions on Website

Monday, November 24th

– Exam 2
 Internal Pay Markets

• Basic Theory equates MRP (Marginal Revenue Product)

with Wage (earnings)
• We have talked about a few extensions:
– Impacts of Training
– Job Market Signaling and Wages
– Incentive Compensation
• Consider more about the Lifetime Pay
– Efficiency Wage
– Upward Sloping Wage Profiles
– Promotion Tournaments
 Efficiency Wages

• Why would a firm pay more the MRP?

• In what type of industries might you see this occur?
• When might you see it during an employee’s career?
 Efficiency Wages and Termination

• Employee’s Decision: Work hard or not?

• Cost of working hard is $50
• If employee doesn’t work hard, firm can detect with
probability of p < 1.
• Firm pays w
• Next best alternative is w**
 Efficiency Wages and Termination (2)
• If employee works hard gets:
– w - $50
• If doesn’t work hard gets
– pw** + (1-p)w
• (p chance of getting fired, 1-p of keeping job)
• Will work hard if:
– w - $50 > pw** + (1-p)w
– or
– p(w-w**) > 50  w > w**
• Intuition:
– Tradeoff between monitoring (p) and wage. If:
• Monitoring is expensive then low p and need higher wage
Efficiency Wages -- Evidence
Wage Differentials by Industry
 Job Seniority and Pay

• Why does salary increase with tenure on the job?

• Are these increases in salary proportionate to increases
in productivity and performance?
• If not, why not?
• Is there an element of efficiency wage in this?
 Job Seniority and Pay (2)

• Assume that:
– Firms cannot perfectly monitor performance
• Suppose that firms offer a salary such that:
– Salary < MRP for employees with little tenure
– Salary > MRP for employees with long tenure
 Upw ard Sloping Earnings

Compensation
MRP
Salary

Tenure
 Job Seniority and Pay (3)
• Effects:
– Younger workers have incentive to work hard & not get
dismissed
– Older workers also have incentive since they are
earning a premium
• Issue
– Firm has incentive to fire anyone with Salary > MRP
– Can it credibly commit not to do so?
• Explicit “Seniority” rules for layoffs in downturns
• Reputation – if it fires older workers, younger works reduce
their performance incentives.
• Forced retirement allows firm to end MRP > Salary in a credible
way.
 Promotion

• Hierarchical firms typically base compensation on a

specific job level (Asst. Manager, Manager, Director, VP)
• Promotion to these ranks is generally based on a
tournament – competing against others in the firm for a
job.
• Then it is relative performance that matters
– Advantage – reduces the role of other factors and
therefore risk in evaluation.
 Promotion (2)

• Why have significant increases in pay with promotion?

• Employee effort will be based on how effort affects
probability of promotion:
– Payoff from effort: p(e)(w*-w) – c(e)
• p(e) – probability of promotion
• w* -- salary with promotion
• w – salary without promotion (current)
• c(e) – cost of effort
 Promotion (3)
• Properties of Promotion Tournaments:
– Effort increases with difference in salaries
– If firm adds employees to tournament to keep same effort must
increase prize (salary with promotion)
– With successive rounds (promotions) to keep same effort must
increase prize (difference in salaries)
• Advantages of Tournaments
– Reduces problems trying to differentiate between similar
employees.
• If attempt to divide pool among almost equal, little incentive to be
best
– Controls for common random factors in evaluation
• Disadvantages of Tournaments
– Conflict in providing incentives for lower-level jobs and selecting
best person for higher-level job.
– Employees have incentive to not work with or even against fellow
employees.