Financial Compensation and Motivationn

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Economics of Human Resources

Part 4: Financial Compensation and Motivation

Lecture 1: introduction - effort

Firms must pay workers to perform tasks that they would not otherwise perform. This is not as straight forward as it seems. We can readily observe a wide variety of compensation schemes that firms use to induce their workers to perform. When is it appropriate to use one particular compensation method instead of another?

Note: In previous lectures, we talked about choosing between paying a straight salary or paying a piece rate but the only issue that we considered was sorting when workers have asymmetric information about their abilities. Now we will examine the implications of various payment schemes on the productivity of any given type of worker, where productivity is (at least to some degree) under the control of the worker.

Two general types of compensation systems are 1) salaries and 2) output-based pay. A salary is defined as payment by input, while output-based pay is defined as payment by a particular measure (or measures) of output.

Salaries are usually tied to some measure of input, which are sometimes rough. For example, an annual salary does not depend on the amount of output that an individual produces in that year, but only that he/she show up for work during most of the work days of that year. For this reason an hourly wage is also defined for our purposes as a salary. An hourly wage does not depend on the worker's output, but rather on the fact that the worker is there on the assembly line or at the word processor during the hour for which ohe is being paid.

Examples of output-based pay include:

Piece-rates: workers earn a certain amount for each item produced (ex: meat workers are paid per carcass processed, garment manufacturers are paid per article of clothing completed)

Commission: workers receive a proportion of the value of the items they sell (ex: sales persons, cab drivers)

Bonus schemes: workers receive a base salary plus an output-based component that is directly related to individual performance (ex: stock brokers, fund managers, company directors)

Profit sharing: bonus schemes linked to the performance of a group of workers or to the entire enterprise

Although by far the most common method of compensation is payment for time worked, the most obvious way to create incentives to work hard and avoid shirking is to compensate workers in terms of the value of their output.

This section of the course is on the relationships between compensation systems that reward workers for performing tasks that they would not otherwise do and the nature of the workers’ actions at work.

Consider a simple work relationship where the employee has one task and must decide how much effort to devote to the task. The task results in output for the firm, which it can then sell at the going price. When the employee exerts effort, s/he is more productive and more output (and so revenue) is generated. However effort is costly to the worker. Clearly the worker is better off with higher pay and worse off with higher effort levels, other things equal. The firm is better off with more output as long as the additional output adds more to revenue than it does to costs.

Assume that each unit of effort produces one unit of output for the firm. Each unit of output generates $240 net revenue for the firm, where net revenue means revenue minus all non-labour costs.


The cost to the worker of a given level of effort is:

EffortCost to workerMarginal Cost of extra effort to the worker 00--

Is there an overall ‘best’ level of effort in this example? An effort level is ‘pareto-efficient’ if no other effort level could make one party better off without making the...
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