Economic Models of Employee Motivation

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Joseph A. Ritter is a research officer at the Federal Reserve Bank of St. Louis. Lowell J. Taylor is an associate professor at the Heinz School of Public Policy and Management, Carnegie Mellon University. Eran Segev and Joshua D. Feldman provided research assistance.

Economic Models of Employee Motivation
Joseph A. Ritter Lowell J. Taylor

use the terms “wage” and “compensation” interchangeably throughout the article) high enough to deter undesirable behavior by making a job too good to lose are said to pay efficiency wages. It is fairly easy to see whether a firm is using some sort of piece rate plan. There is quite a bit of controversy, however, about whether firms that do not use piece rates adopt efficiency-wage or performancebonding plans. We follow our overview with a discussion of the nature of the evidence supporting the different models.


o most people it is a common sense proposition that hiring workers is a trickier problem than buying ballpoint pens. It is often difficult to find the right worker to hire, and workers who have already been hired can quit, steal, be hung over, refuse to cooperate with other workers, or simply not work very hard. In some workplaces some of these problems are relatively easy to solve, either by direct supervision or by directly linking pay to production. In general, however, things like ability, effort, and honesty are difficult to verify and consequently present special problems for personnel managers and economic theorists. The ways firms solve the problems of selecting, motivating, and retaining employees are potentially interesting to a wide cross-section of economists because they can affect how labor markets function and, therefore, how the entire economy operates. This article presents an overview of economists’ main hypotheses about the compensation strategies businesses use to address these kinds of problems. Broadly speaking, these solutions fall into three categories (with considerable diversity within each): piece rates, performance bonding, and efficiency wages. Piece rates link pay directly to workers’ output. Performance bonding uses a combination of up-front payments from workers and conditional repayments to guarantee workers’ performance. Firms that pay wages (we

On one level, economists can analyze labor markets using the same supply-anddemand model they might apply to, say, wheat. Supply increases as the price (wage) received by the supplier increases. Demand increases as the price paid decreases. Equilibrium occurs where supply equals demand. For many purposes it is important to recognize that workers are not perfectly interchangeable; most nurses are not economists. This complication is easily handled by treating the markets for nurses and economists separately, each with its own supply and demand curves. Similarly, workers within the same profession are not typically interchangeable. An important dimension along which different kinds of workers can be distinguished is the collection of applicable knowledge and skills that economists call human capital. Levels of human capital vary not only across individuals, but also over time for a given individual. As an employee accumulates human capital, or as existing human capital deteriorates, the employee’s compensation can be expected to change. A worker’s willingness to accept a particular job will be affected by agreeable and disagreeable facets of the job. Workers require a higher wage to accept a hazardous

F E D E R A L R E S E R V E B A N K O F S T. L O U I S



job than a safe one. They may accept lower wages to work in a nice place, have flexible hours, or perform work that requires little effort. Differences in wages that come from these kinds of reasons are called compensating differentials. The theory of labor demand is especially important for this article. The core of that theory is based on...
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