INCENTIVE PAY

Borjas, 2013. Chapter 11

Pendahuluan
• Throughout much of this book, we have studied the nature of the employment contract in what are called
spot labor markets. In each period, firms decide how many workers to hire at given wages; workers decide
how many hours to work; and the interaction of workers and firms determines the equilibrium wage and
employment. Once the market “shouts out” the equilibrium wage, workers and firms make the relevant labor
supply and labor demand decisions. In these spot labor markets, the wage equals the worker’s value of
marginal product.
• This chapter analyzes in more detail the nature of the employment contract between the worker and the firm.
The problem with the simple story of how spot labor markets operate is that the nature of the labor market
contract affects both the productivity of the workforce and the profits of the firm. The type of labor market
contract matters because employers often do not know the workers’ true productivity and workers would like
to get paid a high salary while putting in as little effort as possible.
• Some firms, for instance, might choose to offer workers a piece rate for their efforts, whereas other firms
offer workers an hourly wage rate. Because the piece-rate worker’s salary depends strictly on how much
output is produced, he or she “works hard for the money.” The time-rate worker’s salary, however, is
essentially independent of current effort, so the worker will want to shirk on the job. If it is difficult for the
employer to monitor a worker’s activities, the time-rate worker can get away with daydreaming, Web surfing,
making personal phone calls, and reading the gossip in the tabloids during work hours.
 11-1 Piece Rates and Time Rates
• The simplest way of showing the link between the method of compensation and the work
incentives of workers is to compare two widely used pay systems: piece rates and time rates. A
piece-rate system compensates the worker according to some measure of the worker’s output. For
example, garment workers might be paid on the basis of how many pairs of pants they produce;
salespersons are often paid a commission based on the volume of sales; and California strawberry
pickers are paid according to how many boxes of strawberries they fill.
• In contrast, the compensation of time-rate workers depends only on the number of hours the
worker allocates to the job and has nothing to do with the number of units the worker produces, at
least in the short run. Over the long run, of course, the firm will make decisions on retention and
promotion based on the worker’s performance record. For simplicity, we assume that the weekly
earnings of time-rate workers depend only on hours worked, and do not depend on the worker’s
performance.
 11-2 Tournaments
• Throughout much of this book, we have assumed that the worker is paid according to an absolute
measure of performance on the job. For example, if the worker’s value of marginal product is $15 an
hour, the worker’s wage equals $15. In some situations, however, the labor market does not reward
workers according to an absolute measure of productivity. Rather, the rewards are based on what the
worker produced relative to other workers in the firm. In effect, the firm holds a tournament, or a
contest, to rank the workers in the firm according to their productivity. The rewards are then
distributed according to rank, with the winner receiving a sizable reward and the losers receiving much
smaller payoffs.
• The reward structure in amateur and professional sports illustrates this type of labor market. The
winner of the 2010 British Open (Louis Oosthuizen) received $1.4 million, while the golfer ending up in
second place (Lee Westwood) got only $800,000. The wage gap between the two players had nothing
to do with the difference in the quality of play. Instead, the compensation is determined solely by the
relative standing of the players; one player ended up in first place, the other in second. Similarly, the
financial rewards in the competitive world of ice skating are determined mainly by the color of the
medal won in the Olympics. A popular winner of an Olympic gold medal can earn millions of dollars
annually by endorsing products, charging fees for personal appearances, and participating in touring ice
shows. In contrast, the winner of the bronze medal will take home only $500,000 annually. The actual
difference in productivity between the gold and bronze medal winners is hard to discern. In fact, the
judges often disagree substantially over the ranking. Nevertheless, to the winner go the spoils
How Much Effort Do Tournaments Elicit?
11-3 Policy Application: The Compensation of Executives
11-4 Work Incentives and Delayed Compensation
11-5 Efficiency Wages