Exchanging your efforts in return for wages is quite possibly the most important transaction in the entire economy. The amount a firm pays you directly affects their bottom line profits and your quality of life. I’m not going to tell you how to live your best life, but for me, living my best life is providing for myself and my family so that we can live comfortably without having to think about how we’re going to foot the bill. And so probably like many of you reading this, I’ve invested the last 23 years of my life in school trying to figure out what I’m good at, what I love, and what I can do to make the most significant impact. Our entire academic career has revolved around learning the tools we need to make a positive contribution to our communities. ECON 152: Personnel Economics gives us a better way to think about how to go do it.
Motivation and Selection
Personnel Economics studies the selection and motivation of employees. Selection covers (1) Choosing from an applicant pool, (2) Assembling an applicant pool, (3) Attracting an applicant pool, and (4) Structuring pay/benefits/duties in such a way that allows you to retain those you select from the pool. Motivation means inducing workers to internalize the goals of the enterprise. In addition to explicit monetary incentives (variable pay plans) such as bonus and/or performance-based plans, motivation includes (1) Harnessing intrinsic motivation (2) Harnessing/being aware of behavioral biases, (3) Setting overall pay generosity and dismissal policy, (4) Wage fairness and inter-worker comparisons, (5) Managing competition among workers, and (6) Inducing cooperation among workers.
If I’ve learned anything about social science, it’s that the field relies on simple models that provide a concise, systematic, and measurable version of reality. None of the models are overly complicated at face value, and Personnel Economics seems to follow suit – motivation and selection – simple. However, analyzing and understanding these two variables in depth provides a wealth of information. It opens a window of opportunity for employers to stop playing power politics with employees out of fear or pure greed. Employment and human resources management do not have to be a zero-sum game when everyone is working towards the same goals.
Personnel Economics is almost never about maximizing profits at workers’ expense. “Good” personnel policies are win-win in that they make both firms and workers better off. In other words, good policies are Pareto-improving or Pareto-optimal and make the pie bigger. “Bad” personnel policies are a win for the firm but a loss for the employee – for example, refusing to buy fruit snacks for the break room would save money at the cost of employee job satisfaction. Everyone except the enforcer responsible for making those bad decisions, whose only goal is to make it clear who’s running the show, loses in the long-run.
Happier employees are more productive, and when employees are more productive, the company can build more stuff and make more money. It’s not rocket science. And so the question in personnel economics then becomes, what do you do with owners/management/employees that let their lust for power come before the goals of the company as a whole?
Competitive labor markets can force even the most self-interested employers to provide Pareto-improving personnel policies. When applicants have other good options to choose from, employers have to compete with those options to attract and retain workers. Continued greediness would only lead to unfilled job positions and revenue left on the table. The competition gets the best workers; the competition gets the project that you can’t fulfill in time; the competition gets to keep building.
Pareto-improving compensation plans structure employment contracts in a way that motivates employees to do their best work, which, in turn, indirectly benefits the owners. Earnings-based bonus schemes for rewarding executives because it motivates them to act in the best interest of its shareholders. Attaining earnings-per-share objectives and other benchmarks laid out in the plan provides a direct bump to annual take-home pay for company’s leadership team. These measures simultaneously benefit shareholders through the increase in share value. In short, earnings-based bonus schemes align the interests of company leadership and owners, and everyone seeks to benefit.
A quick side note: Dr. Robert Higgs from the University of Washington studied the organization of southern agricultural business in 1910, with a particular focus on the relationship between race, land tenure conditions (owner vs. renter), and the allocation of resources.
Census data shows that the raw distribution of land tenure varied significantly among white and black farmers. Black farmers were less frequently owners and more frequently tenants than were white farmers. Of the white tenants, almost 74 percent paid the landlord a share of the product as rent, whereas about 57 percent of black full tenants paid share rents. However, the difference in the distribution of farm rental contracts between share-rent and fixed-rent among blacks and whites is insignificant when adjusted for total acreage cultivated by tenants and geography. So, whatever determined the distribution of rental contracts affected both races in the same way.
Higgs went on to assert that yield risk and the percentage of rented acreage under share contracts are directly related. The higher the risk of fluctuations in yield, the higher the proportion of share-rent contracts. Why?
Share systems place more risk in the hands of landlords than fixed-rent systems and vice versa for the tenant. Farmers that agree to fixed-rent contracts have to pay the landlord a given amount every year, regardless of whether their acreage yields $1 million or $1. It’s like in Goodfellas when Paulie buys the restaurant – “Business bad? Oh, you had a fire? Place got hit by lightning?” – The owner had to come up with Paulie’s money no matter what. The manager/operator takes on 100% of the risk.
In areas faced with more contingencies impacting crop yields like less consistent weather patterns, fixed-rent contracts put an insurmountable amount of risk on the tenant. But the landlord, who also doesn’t want to take on any risk, could care less. So what do they do? The fact that both parties want to minimize their risk and maximize their profits is at the foundation of insurance markets.
The amount of rent a landlord expects to receive from a share-rent contract always exceeds the value of fixed rents. This is the market mechanism for providing the landlord with a higher return when he bears a portion of the risk. When risk increases, those least averse bear proportionately more of it. This explains, at least in part, the higher proportion of share-rent contracts among white farmers in the south at the turn of the century.
Higgs prefaced his results for 1910, stating, “These conclusions are tentative; they may well be wrong.” According to his findings, race had a relatively small influence in the determination of farm size and had little to no effect in determining the division of farm rental contracts between fixed-rent and share-rent forms. The determining factor was risk.
The key takeaway: Share-rent contracts distribute the level of risk assumed in the contract to each party. Consequently, the greater the risk of fluctuations in yield, the higher the prevalence of these types of agreements.
Earnings-based compensation
Does Jeff Bezos deserve his paycheck? Couldn’t the board of directors just as easily pay him a fixed base salary and call it a day? Bezos’ base salary last year was $81,840. Why should he earn extra?
The idea that someone would bring their A-game to carry the weight of $886B in market cap and more than 2 million shares trading hands every day in exchange for $81,840 a year is laughable. First, consider the skills a company needs to win and then look around you – what happened to basic supply and demand? Then think what would happen if Bezos took his talents elsewhere. What happens to Vanguard, BlackRock, or T. Rowe? What if he just stopped showing up?
Quality control slipping? Customers not happy? Earnings missing analyst expectations? https://www.youtube.com/watch?v=8L4HHPTiZN8
The reasoning behind Bezos’ salary lies in the risk the company’s owners face from productivity losses due to a lack of motivation. It goes without saying that an employee wouldn’t feel the same amount of pressure to grind it out if there was no individual incentive to making the company more money. Handing someone a hall pass to take home a definite amount of income every year, regardless of whether they work from 8am to 8pm or only show up three days a week when it’s convenient, is dangerous. And it’s especially risky if they play a vital role in the success of the organization.
The distribution of variable pay contracts through bonuses and stock options across an organization is not dissimilar to the proportion of share-rent contracts in the organization of southern agriculture in 1910. In situations where the risk that crop yields would fail to generate enough income to fulfill the promised fixed rental payment was too high for a risk-averse tenant, landlords were able to step in and bear some of the risks in exchange for higher rent. The solution to set rent equal to a percentage of the yield pushed both tenant and landlord interests closer together as each party was positioned to share in profits and losses. Similarly, in situations where one manager has a high level of responsibility for a company’s financial performance, it’s in the owners’ best interests to utilize something like a share-rent set up and give them a piece of the pie as well.
The best way to structure the exchange of effort for pay is not at all obvious. Consider the following two extremes:
- Workers are inherently lazy and stronger financial incentives are always better
- Workers are intrinsically good and will do what is needed with a minimum of financial incentives
Unsurprisingly, both views can lead to terrible results. Bad HR Management (HRM) policies create massive inefficiencies and undoubtedly hurt the overall productivity of an enterprise. The other side of the coin shows that effective HRM can be highly profitable and make workers’ lives better too. We’ll study some cases where simple, correctly-targeted HRM innovations can yield gains that compare very favorably with the best technological innovations.
What’s next?
Principal-agent model: economists’ ideal workhorse for studying the optimal design of contracts, institutions, and financial incentives.
Thought Experiment: Imagine you have just been seriously injured in an accident in one of the big box stores. You need to hire a lawyer to sue the store for damages. How should you pay this person?
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