Performance related payPerformance related pay

• 1. Background1. Background

• 2. Effects2. Effects

• 3. Empirical evidence3. Empirical evidence

• 4. Problems with PRP4. Problems with PRP

1. Background1. Background

• RecallRecall– Output depends on worker effortOutput depends on worker effort– Workers have free will Workers have free will

•effort & specific skillseffort & specific skills

•effort is a ‘bad’, higher wages are a ‘good’ effort is a ‘bad’, higher wages are a ‘good’

– Firms wish to maximise effort / skill Firms wish to maximise effort / skill useuse•Divergence of interests – principal-agent Divergence of interests – principal-agent

problem problem

• Informational asymmetries Informational asymmetries

1. Background1. Background

• ‘‘Old Pay’ versus ‘New Pay’Old Pay’ versus ‘New Pay’– ‘‘Old pay’ systemsOld pay’ systems

• job evaluated grade-wage structurejob evaluated grade-wage structure

• pay = f(time, seniority, job characteristics)pay = f(time, seniority, job characteristics)

– ‘‘New Pay’ systemsNew Pay’ systems•Pay related to firm’s strategyPay related to firm’s strategy

•Flexible & variable pay systemsFlexible & variable pay systems

1. Background1. Background

• Types of PRP incentive Types of PRP incentive schemescheme– (i) Piece rates: w = f(Q)(i) Piece rates: w = f(Q)– (ii) Commission on sales(ii) Commission on sales– (iii) Group-based PRP I.e. bonus (iii) Group-based PRP I.e. bonus

systems (US = ‘gainsharing’)systems (US = ‘gainsharing’)– (iv) Profit sharing(iv) Profit sharing

2. Effects of PRP2. Effects of PRP

• Three (expected) effects, Three (expected) effects, compared to what?compared to what?– (i) Effort & output will rise(i) Effort & output will rise– (ii) Average level of earnings will (ii) Average level of earnings will

riserise– (iii) Variance of effort & wages (iii) Variance of effort & wages

across workers in a firm will riseacross workers in a firm will rise

3. Empirical evidence3. Empirical evidence

• Lazear (2000)Lazear (2000)– Safelite Glass Corporation Safelite Glass Corporation – DataData

•3,707 workers, 19 months = 38,764 ‘person-3,707 workers, 19 months = 38,764 ‘person-months’months’

•Output = average no. of glass units installed Output = average no. of glass units installed per day in a monthper day in a month

– MethodsMethods•Regression with & without fixed effectsRegression with & without fixed effects

3. Empirical evidence3. Empirical evidence

• FindingsFindings– Output per worker rose by 44 percentOutput per worker rose by 44 percent

• A) average worker produces more – incentive schemeA) average worker produces more – incentive scheme• B) hire more productive workers & reduction in quits B) hire more productive workers & reduction in quits

amongst the most productive workersamongst the most productive workers

– Workers received a 10 percent increase in payWorkers received a 10 percent increase in pay– Variance in output increasedVariance in output increased– Effect on profits?Effect on profits?– Effect on quality of output?Effect on quality of output?

• Effects are large & in line with economic Effects are large & in line with economic theorytheory

3. Empirical evidence3. Empirical evidence

• Gregg, Jewell & Tonks (2005)Gregg, Jewell & Tonks (2005)– Executive pay & company performance in the Executive pay & company performance in the

puzzlepuzzle– Panel data - UKPanel data - UK

• Time: 1994-2002Time: 1994-2002

• Companies: 415 Companies: 415

• Total observations 2,859Total observations 2,859

– Methods Methods • ExecPayExecPayitit==µµii + + ααtt + + ββ11(CompPerform) + (CompPerform) +

ββ22(Controls) + e(Controls) + eitit

3. Empirical evidence3. Empirical evidence

• LiteratureLiterature– Low pay-performance sensitivities for UK Low pay-performance sensitivities for UK

firms (elasticity= 0.15)firms (elasticity= 0.15)– Total compensation matters moreTotal compensation matters more

•Main et al (1996) – share option – elasticityMain et al (1996) – share option – elasticity– increased from 0.15 to 0.71 (total board increased from 0.15 to 0.71 (total board

remuneration)remuneration)– Increased from 0.23 to 0.9 (highest paid director)Increased from 0.23 to 0.9 (highest paid director)

3. Empirical evidence3. Empirical evidence

• FindingsFindings– Total board pay rose by 33% over the Total board pay rose by 33% over the

periodperiod– Mean pay of highest paid director Mean pay of highest paid director

increased by 45% in real termsincreased by 45% in real terms– Regression resultsRegression results

•Firm size has the biggest effect Firm size has the biggest effect

•Total share holder return has a much Total share holder return has a much smaller effectsmaller effect

4. Problems implementing PRP4. Problems implementing PRP

• a) Individual output – difficult to measurea) Individual output – difficult to measure

• b) Time & performanceb) Time & performance

• c) Team production, effort & outputc) Team production, effort & output

• d) Teams & Group outputd) Teams & Group output

• e) Multi-task workers – performancee) Multi-task workers – performance

• Other pay mechanisms Other pay mechanisms