Team Production, Concentrated Rewards:the paradox of work and pay

Richard B. Freeman, Harvard, NBER, and CEP, LSEGreen Templeton College, Oxford, Future of Work Oct 18, 2011

The Issue: increased importance of team/cooperative work in economy coincident

with rising inequality in pay

This talk:

1- Evidence on team/cooperative and inequality in science-engineering (paper authors), with side note on the rise of supply chains

2- Evidence on group incentives vs incentives for top executives.

3- What is fair/efficient division?

4- Toward a better world of work

The rising inequality in pay

The Wall Street Occupiers emphasis on the upper 1% is wrong. In the US it is the upper 0.1%. Share of pretax income earned by top 0.1% increased from 2.7% to 12.3% (2007). Rest of upper 1% increased from 5.3% to 5.7%.

Who are the 0.1%? Two-thirds are executives, managers, supervisors, financial professions + real estate

This means “income of 99.9% of Americans would have increased by almost 10% if share of 0.1% was constant.”

Within the upper 0.1% ???, it is possible –likely? – we would find similar fractal dimension of inequality – wealth of billionaires in Forbes follows power law.

The World's Billionaires-- Forbes March 2011

Two hypotheses to explain phenomenon

H1: Efficient production. Modern ITC has expanded role of coordination/span of control – superstars in global Internet economy. “Masters deserve what they get. Do what you’re told or the ship will sink.”

H2: Crony capitalism. Small elite has taken control of business and government and extracted huge economic rents as the purported residual claimants on production.

Crony? Are you kidding? I deserve my billions. It’s hard battling Morgan Stanley, Citicorps, and Goldman daily, those unscrupulous sleazebags with all their connections in the Beltway”

Divergent views on the hypotheses

1.Teams in Science and Engineering

TEAM

Is there a payoff to multi-authored papers? YES

Analysis: Use five year forward citations to measure merit of a paper (about 1/3rd of papers are never cited!). Based on articles in ~22,000 journals from Thomson-Reuters “Web of Science” data, 1950-2003.

Once about a time

Now

But power Laws for cites for individuals

Papers: mode is 0; 30-40% “never cited”;competition between papers among and within generations

Science need instruments, equipment, data → Grants. Compete in a tournament with peer

review. Guess who gets the grants?

I don’t do the researchor write articles, either, butI raise the money so I get the credit!

Paula Stephan, tabulated from Survey of Doctorate Recipients, for forthcoming HUP book

Does tournament structure affect supply? Niederle &Vesterlund (2007) Experiment: add five 2-digit

numbers randomly drawn and presented in the following way: 21 35 48 29 83

Side note on Supply Chains and Fragmentation

Signs of Problems: postdocs organize National Postdoc Association (“not a union”,

then unionize)

You work in for a Prof who you believe falsified data on a grant application that covers your pay. What do you do?

In 2006 Science reported that after several months of debating, six graduate students working in Elizabeth Goodwin's genetics lab at the University of Wisconsin decided to tell university officials. A university investigation subsequently found that Goodwin had falsified data. She resigned.

“When she resigned and the university forfeited her funding, her lab closed down. That meant the students were out of work — no salaries, no tuition reimbursement, and perhaps worst of all, no research. That would mean no progress on their degrees, and starting over.”*

“One, Chantal Ly, had gone through 7 years of graduate school and was told that much of her work was not useable and that she had to start a new project for her Ph.D... Along with two of the others, she quit graduate school. … (Another), Allen moved to a school in Colorado. Just two students chose to stay at UW.” # One, Amy Hubert, got her PhD.

* John Allen Can of Worms, Wisconsin Alumni association,

# Jennifer Couzin-Frankel, Science Insider, June 28, 2010

2. Growth of incentive pay: group incentives in US, 2002-2010

Associated with employee involvement (EI) committees, teamwork: more likely to have EI if have group incentive pay and conversely. Systems called high performance work places. Compensation systems have local group incentives, company-wide incentives, individual incentives, etc.

“Preponderance of Evidence” says group incentives work

Reviews on employee ownership conclude that “two thirds of 129 studies [including both performance and attitude studies] on employee ownership and its consequences found favourable effects relating to employee ownership, while one tenth found negative effects”, and that “research on ESOPs and employee ownership is overwhelmingly positive and largely credible.” Meta-analyses that combine estimated parameters from studies report a strong positive association between inclusive capitalist modes of compensation and performance.

The UK Treasury commissioned Oxera (Oxford, London) in 2007 to examine impact of tax breaks for individual employee stock ownership, using confidential financial information. Estimating production functions for 16,844 corporations, this study found that the shared capitalism approaches increased value added per worker by about 2.5% in the long run.

• A study of workers based on over 41,000 worker reports in 14 firms with some form of employee ownership, profit and gain sharing, and broad-based stock options finds that worker co-monitoring helps overcome the incentives to free ride because workers with a greater stake in performance monitor each other more closely and are more willing to intervene to reduce shirking behavior than workers with less stake. Workers in these firms perform better the greater the depth of the incentive compensation system. The systems increased employee attachment, lowered turnover, prompted employee suggestions for improvements, and worked best with other “high performance” labor practices and policies. 

New StudiesHan and Ouimet (2011): Changes in wages and firm value following

ESOP adoptions are related to the ESOP size. When it is less than 5% of outstanding shares, both mean wages and firm values increase. Since shareholders and employees are the two main claimants of firm surplus, these changes suggest small ESOPs increase productivity. But large ESOPs have neutral effects on wages and shareholder value. Why the difference? Ownership affects company culture in small but large ESOPs often are financial gimmick not effort to improve group incentives and co-monitoring.

Hochberg and Lindsey (2010) Options granted broadly to non-executive employees exhibit higher subsequent operating performance, with the implied incentive-performance relation concentrated in firms with fewer employees and in firms with higher growth opportunities.

1300 corporations applied in 2006-2008 for making the Great Place to Work Institute 100 Best Companies list. They filled out a management survey & had random employees take anonymous surveys → 300,000 responses. We merged with DOL 5500s and S&P Compustat.

1) Many of the 100 Best have some form of shared capitalism: 17% have ESOPs, 10% are majority employee owned, 16% give options to most employees.

2) More shared capitalism --> more high performance work practices and higher Trust Index of workers.

3) As shared capitalism and the Trust Index go up together, the market value of the firm rises relative to book value of assets Tobin’s Q.

Great Places to Work (Blasi, Kruse, Freeman, 2012)

Elsewhere pay concentrates at top

USA TODAY, APRIL 1, 2011

Main reason? Top earners tap into capital income as incentive pay seeks to resolve principal/agent issues.

The View that Huge Options to top executives are critical for firm success assumes

1 – Key decisions in large organizations depend critically on top person rather than whole organization or2- That top person is irrelevant but the pay at the top motivates other employees, and3 – That the contracts give them “right” incentive rather than opening ways to game the system, through chicanery or financial manipulation.*

* US Supreme Court June 2010 decision on Enron said the law the firms/public has an "intangible right of honest services” used to prosecute Enron and some politicians is too vague opens door for more legal gaming.

Do big incentives at top improve firm performance?

YES. CEO-appointed board bargains at arms-length with CEO over contract to resolve principal-agent problem in efficient market. Test? No need to test. Efficient market theory says it is so.

What if there is no correlation between incentive pay and future share prices? Just what the theory predicts on the margin. What if the relation is positive? Shareholders did not appreciate the power of option incentives. Give more options.

What if the relation is negative? Negative! Why would they ever do that? NO. The incentives are rent-seeking. Executives extract $$ by dominating boards through corporate governance procedures or by gaming whatever option rules the board sets (Bebchuk &Fried; Black, for bankers). Test?

What do we know about incentives and performance StStudies (Hall & Liebman) show that when company does well executives do well, especially in options. Some studies find negative correlation between option $$ this period and future share price. But current option is not incentive for future. Could be firm is lucky in period one, options pay off, and regresses to mean.

“Correct” analysis looks at derivative of value of option wrt share price (Black-Scholes delta). Problems of backdated options, manipulation of news, multiple option holdings. Our analysis shows that corrected for backdating, multiple options, delta of option package has 0 to modest negative effect on future prices.

Interpretation: Options are way to skim random variation in share prices/company performance for execs. Test is what happens when options go under water.

Question: You are a top exec. Your options are underwater. What does YOUR board do?

Nothing? On the notion that you failed the incentive and they don't want to reward you for failing to meet incentives. About 20%

Eighty-one percent take action to restore executive wealth:

Reprice the option? Common until FASB required repriced options count as compensation expense, then shift to “6 and 1” option to avoid new ruling.

Give you “unexpected bonus”

Give you “unexpected options”

(Balachandran, Carter, Lynch, 2004)

Question: You are still a top exec. Share prices fell because Wall Street collapsed. What do you do?

3. What is Inequality-Output relation is an Inverse ULower inequality costs (raises) output if economy is to

the right (left) of I*

Output

Inequality

I*

Fair US current?

The Maze-Solving Experiment

Groups of six.

Round 1 – everyone does piece rate; informed about scores in group

Round 2 – high, medium, no inequality

Reported output at given incentives

14.5

15

15.5

16

16.5

17

17.5

18

18.5

19

equal pay

all incentives

top wins all

Number of mazes per person misreported at

given incentives

Source: Freeman and Gelber, 2010

4. Toward a Better World of Work

1) Distribution and efficiency are related: need inequality to motivate people but too much is socially destructive by generating rent-seeking instead of production.

2) Upper 1%, 0.1%, etc will not give up much of their income/wealth without struggle,but they have/will overreach as part of human nature.

3) Crony capitalism is endemic to market capitalism/human nature, rather than being some developing country disease.

Cut our pay and power? Never!

4) The misalignment of working as team and dividing rewards as lords and serfs is inefficient

5) Global problems (RD commons, global warming, pandemics, etc) require group coordination

6) Efficient economies should triumph over inefficient systems

So saith, the

Invisible Hand

But IH needs

help from visible hands

Remember America's greatest thinker Dr.Seuss: the Grinch Stole Christmas but

Horton and the Whos win in the end

Are you sure the whos can beat the grinches in the real world?

Of course, I am sure. Economists know a lot.

Social science is never wrong. And I did some high-powered computer simulations. And the computer is never wrong.

But, on the other hand, my simulations of the dynamic general equalibrium of the interactions of grinches and whos in Calibi-Yau space has an attractor of economic feudalism.

If the physicists cannot solve multi-body problems and string theory has millions of possible universes as solutions, how could any social scientist be all that sure of anything?

Hey, this looks like a chance to make some money. Anyone interested in credit default swaps on the success of those whos?

And if you want to bet the other way, I got some Madoff bonds that Goldman goes belly up.

Who goes down first? The US or the Euro?

Will the China bank system collapse under bad loans? Will Italy ever get rid of Berlusconi? Will Murdoch survive? I don't give a damn what happens – the house always makes money.