Deck 11: Incentive Pay

Question 1

Suppose there are 100 workers in an economy with two firms. All workers are worth $35 per hour to firm A but differ in their productivity at firm B. Worker 1 has a value of marginal product of $1 per hour at firm B, worker 2 has a value of marginal product of $2 per hour at firm B, and so on. Firm A pays its workers a time-rate of $35 per hour, while firm B pays its workers a piece rate. How will the workers sort themselves across firms Suppose a decrease in demand for both firms' output reduces the value of every worker to either firm by half. How will workers now sort themselves across firms

Answer 1

The workers are likely to sort their work according to their abilities. Higher ability workers prefer to work with firm 'B' considering that it offers piece-rate compensation system. Workers 1 to 34 opt for firm 'A' considering that the time rate offered by the firm is greater than their value of marginal productivity.
A decrease in demand for the output produced by the workers leads to reduce the wages paid to them. If the both firms 'A' and 'B' are likely to reduce the wages then the sorting of the workers remain unchanged.
More productive workers find no incentives to work with firm 'A' due to reduction in its wages. Therefore if the wages in both the firms reduces by half, then the workers are not likely to change their firms. They would prefer to remain in the same firm.

Question 2

What factors determine whether a firm offers a piece-rate or a time-rate compensation system

Answer 2

In a price-rate system, workers are given compensation according to the number of units of output produced by them. Produced output by the workers is taken into the account while determining the compensation.
In terms of time-rate system, workers are given compensation according to the number of hours worked by them. The number of working hours is taken into the account while determining the compensation in time-rate system.
Following are the factors which are considered while determining whether to offer a piece-rate or a time-rate compensation system.
1. Productivity of workers. Firms prefer to offer time-rate compensation system if the productivity of labor is relatively higher. If the productivity of workers is lower, then firms would prefer to offer piece-rate compensation system.
2. Monitoring cost. Monitoring cost of workers plays an important role while determining whether to offer a piece-rate or time-rate compensation system. If the monitoring cost is relatively higher, then the firms would prefer to offer a time-rate compensation system.
3. Measurement of produced output. If the output produced by the workers is difficult to measure, then the firms prefer to offer a time-rate compensation system. If the output is easy to measure, then the piece-rate system would be preferred.
4. Profitability. The firms offer a system which maximizes their overall profitability. If the piece-rate system leads to maximize the profit, then the firms are likely to offer it to the workers.
Thus, Productivity of the workers, monitoring cost, ease of measuring workers' produced output, and profitability are the factors which determine whether to offer a piece-rate or time-rate compensation system.

Question 3

Taxicab companies in the United States typically own a large number of cabs and licenses; taxicab drivers then pay a daily fee to the owner to lease a cab for the day. In return, the drivers keep all of their fares (so that, in essence, they receive a 100 percent commission on their sales). Why do you think this type of compensation system developed in the taxicab industry

Answer 3

The rental compensation system developed in the taxicab industry due to the monitoring problems. The owners of the taxicabs find it difficult to monitor revenue earned by the taxicab drivers.
There is possibility that the drivers might not inform correctly about the generated revenue. Misinformation from the taxicab drivers leads to reduce the profitability of the taxicab owners.
Thus, considering reduction in the profitability occurred due to monitoring problems, taxicab owners have developed a rental compensation system.

Question 4

Discuss how workers who differ in their innate abilities sort themselves across piece-rate and time-rate jobs. Also describe how the two compensation systems elicit different levels of effort from the workers.

Question 5

A firm hires two workers to assemble bicycles. The firm values each assembly at $12. Charlie's marginal cost of allocating effort to the production process is MC = 4 N, where N is the number of bicycles assembled per hour. Donna's marginal cost is MC = 6 N.
a. If the firm pays piece rates, what will be each worker's hourly wage
b. Suppose the firm pays a time rate of $15 per hour and fires any worker who does not assemble at least 1.5 bicycles per hour. How many bicycles will each worker assemble in an eight-hour day

Question 6

If piece rates elicit more effort from workers, why do firms not use this method of compensation more often

Question 7

All workers start working for a particular firm when they are 20 years old. The value of each worker's marginal product is $18 per hour. In order to prevent shirking on the job, a delayed-compensation scheme is imposed. In particular, the wage level at every level of seniority is determined by
Wage = $10 + (0.4 × Years in the firm)
Suppose also that the discount rate is zero for all workers. What will be the mandatory retirement age under the compensation scheme ( Hint : Use a spreadsheet.)

Question 8

Show how a large prize spread in a tournament elicits a higher level of work effort from the participants.

Question 9

Suppose a firm's technology requires it to hire 100 workers regardless of the wage level or market demand conditions. The firm, however, has found that worker productivity is greatly affected by its wage. The historical relationship between the wage level and the firm's output is given by

What wage level should a profit-maximizing firm choose What happens to the efficiency wage if there is an increase in the demand for the firm's output

Question 10

Discuss some of the problems encountered when firms allocate sizable rewards to the winner of the tournament.

Question 11

Consider three firms identical in all aspects except their monitoring efficiency, which cannot be changed. Even though the cost of monitoring is the same across the three firms, shirkers at Firm A are identified almost for certain; shirkers at Firm B have a slightly greater chance of not being found out; and shirkers at Firm C have the greatest chance of avoiding identification. If all three firms pay efficiency wages to keep their workers from shirking, which firm will pay the greatest efficiency wage Which firm will pay the smallest efficiency wage

Question 12

Why is the principal-agent problem relevant to understanding how CEOs should be compensated

Question 13

Consider three firms identical in all aspects (including the probability with which they discover a shirker), except that monitoring costs vary across the firms. Monitoring workers is very expensive at Firm A, less expensive at Firm B, and cheapest at Firm C. If all three firms pay efficiency wages to keep their workers from shirking, which firm will pay the greatest efficiency wage Which firm will pay the smallest efficiency wage

Question 14

Discuss how upward-sloping age-earnings profiles can elicit more effort from workers.

Question 15

a. The analysis of Figure 11-5 does not mention the price of output. What is implicitly being assumed about the product market in the analysis
b. Instead of thinking of output as depending on the wage level, the analysis in Figure 11-5 can be altered to think of revenue as depending on the wage level. Redraw Figure 11-5 under this approach. Demonstrate the optimal efficiency wage in your graph. Characterize in words the optimal efficiency wage.
Reference Figure 11-5

Question 16

Why is there mandatory retirement in many countries

Question 17

Consider a firm that offers the following employee benefit. When a worker turns 60 years old, she is given a one-time opportunity to quit her job, and in return the firm will pay her a bonus of 1.5 times her annual salary and pay her health insurance premiums until she is eligible for Medicare.
a. What problem is the firm trying to solve by offering this benefit
b. Why is the health insurance premium portion of the benefit important in the United States
c. For what industries might one expect such opportunities to be presented to workers

Question 18

Describe how the firm sets an efficiency wage above the competitive level. Why are there no market forces forcing the profit-maximizing firm to reduce the wage to the competitive level

Question 19

a. Why would a firm ever choose to offer profit-sharing to its employees in place of paying piece rates
b. Describe the free-riding problem in a profit-sharing compensation scheme. How might the workers of a firm "solve" the free-riding problem

Question 20

What factors create the link between wages and productivity that is at the heart of efficiency wage models

Question 21

a. How does the offering of stock options to CEOs attempt to align CEO incentives with shareholder incentives
b. Enron was a company that was ruined in part because of the stock options offered to upper management. Explain.
c. In addition to accounting reforms, how might stock options be changed to try to prevent situations like what happened at Enron from occurring in the future

Question 22

What is the bonding critique of efficiency wage models

Question 23

(a) Personal injury lawyers typically do not charge a client unless they obtain a monetary award on their client's behalf. Why
(b) What would happen to the number of lawsuits if lawyers had to charge an hourly rate and could not charge a fixed percentage of the award

Question 24

The relationship between a worker's daily wage, w , and her daily output, q , is
q = 0.1 w 2 2 - 0.0005 w 3
so that the worker's marginal product with respect to her wage is
MP w = 0.2 w - 0.0015 w 2.
What is the optimal efficiency daily wage for the firm to pay How much output will the worker produce each day How much profit does the firm earn on the worker's output each day if the price of output is fixed at $0.80 per unit.

Question 25

Economists and psychologist have long wondered how worker effort relates to wages. Specifically, the question is whether worker effort responds to increased wages alone or whether effort also responds to relative wages.
(a) Design a classroom experiment that would allow you to quantify the relationship between effort, reward, and relative reward.
(b) Explain how the data you collect can be used to identify both relationships. What do you think you would find
(c) Suppose a consulting firm intends to estimate the following regression for a firm:
output i = 0 + 1 wage i + 2 relwage i ,
where output i is worker i 's hourly production, wage i is worker i 's hourly wage and relwage i is the ratio of worker i 's wage to the publicly known average wage at the firm. How can the results of the regression be used to determine the importance of wage levels and relative wages in the production process

Question 26