Chapter 14 - Attracting And Retaining Qualified Employees

14-1


CHAPTER 14


ATTRACTING AND RETAINING QUALIFIED EMPLOYEES

CHAPTER SUMMARY

This chapter is the first of two chapters on compensation policy (reward system). It
concentrates on how managers design compensation packages to attract and retain
qualified employees. It begins by providing a benchmark economic model of
employment and wages (the standard competitive model). Subsequently, this basic model
is extended to consider the implications of costly information about market wage rates,
compensating differentials, investments in human capital, internal labor markets, and the
choice between salary and fringe benefits.


CHAPTER OUTLINE

CONTRACTING OBJECTIVES
THE LEVEL OF PAY
The Basic Competitive Model
Managerial Application: Setting the Wrong Level of Pay at Salomon
Brothers
Human Capital
Managerial Application: U. S. Lags in Worker Human Capital Skills
Managerial Application: Investments in General Human Capital
Compensating Differentials
Managerial Application: Compensating Differentials on the Slime Line
Managerial Application: Recruiting and Retaining Iraqi Soldiers
Managerial Application: Tight Labor Markets Increase Competition
Managerial Application: Compensating Differentials
Costly Information about Market Wage Rates
Managerial Application: Paying Too Much at Nucor?
INTERNAL LABOR MARKETS
Reasons for Long-Term Employment Relationships
Managerial Application: Internal Labor Markets in Japan
Firm-Specific Human Capital
Employee Motivation
Learning Employee Attributes
Costs of Internal Labor Markets
PAY IN INTERNAL LABOR MARKETS
Careers and Lifetime Pay
Efficiency Wages
Managerial Application: Competition for the Top Job
Managerial Application: Lifetime Employment Collapses at Mitsubishi
Chapter 14 - Attracting And Retaining Qualified Employees

14-2

Managerial Application: Motivating Honesty in the Local Police Force
Managerial Application: The Costs of Wage Compression
Job Seniority and Pay
Promotions
Managerial Application: A Horse Race at General Electric
Influence Costs
Academic Application: Influence Costs and Pay in Universities
THE SALARY-FRINGE BENEFIT MIX
Employee Preferences
Managerial Application: Employment Market Niches
Managerial Application: Employee PreferencesAttire
Managerial Application: Employee PreferencesBody Art
Employer Considerations
The Salary-Fringe Benefit Choice
Managerial Application: Fringe Benefits and Overtime
Using Fringe Benefits to Attract Particular Types of Employees
The Mix of Fringe Benefits
Managerial Application: Trend Toward Temporary and Part-Time
Workers
SUMMARY


TEACHING THE CHAPTER

This chapter is the first of two that focus on a second leg of the stool, reward systems.
Chapter 14 focuses on how to attract and retain qualified employees by focusing on
compensation, where as chapter 15 focuses on incentive compensation. The beginning of
the chapter reviews the basic competitive model that is initially presented in Chapter 6,
and builds on these concepts to discuss labor markets. Students should remember this
material fairly well, particularly since it would have been covered in introductory
economics courses as well, however concepts such as marginal revenue product may
need to be reviewed. Other material in the chapter builds on utility maximization
analysis, initially presented in Chapter 2, and the cost-minimization analysis, presented in
Chapter 5, which might need to be reviewed for some students. However, these tools are
not required to solve the problems in the chapter, so focusing on them would depend
upon the goal of the course, particularly if students feel comfortable with the graphical
presentations in the book.

Chapter 14 - Attracting And Retaining Qualified Employees

14-3

This chapter is one that includes an abundance of Managerial Applications to emphasize
the concepts in the chapter. Other than the use of the microeconomic tools referenced
above, much of the content in this chapter should be understandable for students with a
variety of backgrounds, so rather than lecturing on the chapter, using the applications to
generate class discussion could be a useful way to determine whether students understand
the fundamental concepts. The Self-Evaluation Problems provide excellent preparation
for the Review Questions and the Analyzing Managerial Decisions scenarios. The Review
Questions would also be useful discussion starters for some of the concepts not covered
in the Decisions scenarios.

There are three Analyzing Managerial Decisions scenarios presented in this chapter.
The first, Structuring Cruise Line Compensation, asks students to consider the effect on
employee compensation of offering an additional fringe benefit at the company. This
scenario is a rather simple illustration of the salary-fringe benefit tradeoff. The second,
scenario, Paying for Fringe Benefits at Lincoln Electric, asks students to critically
evaluate a statement about who pays for the fringe benefits. The question again
emphasizes the point that there is a trade-off between salary and fringe benefits. The
third scenario, Structuring Compensation Plans, asks students to consider two different
compensation plans for seemingly similar department stores. Students should consider
not only the relevant material from this chapter, but should also consider the other aspects
of organizational architecture that might lead to these differing compensation schemes.
(See the Solutions manual for the answers to these problems).

REVIEW QUESTIONS

141. Explain the following quotation: "My employer doesn't determine my salary, he
determines where I work."

The level of pay that is required to attract and retain a qualified employee is
often beyond the control of a firm. Rather, the level of pay is determined by
conditions in the labor market. If the firm pays a level that is competitive it
will attract qualified employees, if it does not, the employees will go to other
firms. Hence, in a sense my employer does not determine my salary, rather
he determines where I work. If he does not pay me enough, I will quit and
work at another firm.


142. In the basic competitive model, why do employees pay for general training and
firms pay for specific training?

Employees capture the gains from general training. An employee with
increased general training will have his salary bid up by other firms. In
contrast, the gains from specific training tend to go to the firm. If the
employee pays for this training, there will be no market pressure to increase
his salary to compensate him for the training.

Chapter 14 - Attracting And Retaining Qualified Employees

14-4


143. Why do firms form internal labor markets?

There are at least three primary reasons why firms often use internal labor
markets. First, internal labor markets promote the development and use of
firm-specific human capital. Second, long-term employment relationships
provide firms with extra flexibility for designing pay packages that motivate
employees. Third, long-term employment relationships can provide
important information to employers that can be used to improve the
matching of employees and jobs.


144. Evaluate the following statement: "Firms are free to set salaries in any manner
they want in an internal labor market."

This statement is not true. Firms with internal labor markets do not have to
match spot market wages to employees at every point in time. Nevertheless,
they face market constraints. Employees will tend to migrate to other firms if
the wage package over the careers of the employees is not competitive with
other firms.


145. Present an economic argument to explain why firms often have mandatory
retirement (where allowed by law).

Firms with internal labor markets might find it optimal to pay below the
employees marginal product when the employee is young and above the
marginal product when the employee is old. Such a scheme can have
productive incentive effects. To remain competitive, however, the firm
cannot continue to pay above the marginal product for an extended time
period. Mandatory retirement places a limit on these payments.
Also, dismissing a long-time employee is a difficult decision. With a
mandatory retirement, an individual employee expects to be terminated at
that date.


146. How do influence costs affect pay within internal labor markets?

There is some evidence that they might reduce the dispersion of pay within
organizations. The argument is that this reduction in dispersion limits
complaints and other nonproductive influencing activities.


Chapter 14 - Attracting And Retaining Qualified Employees

14-5

147. The United States congress has considered proposals that would limit the level of
top executive pay to some multiple of the lowest-paid employee in the company
(for example, executive pay must be less than 10 times the lowest-paid
employee). Do you think this type of proposal is a good idea? Explain what
effect the proposal would have on the involved companies.

If the constraint is binding, it will make it more difficult to attract and retain
qualified CEOs. Companies, however, are likely to devise ways to get around
the policy. First, the nonmonetary compensation of CEO's can be increased
(more club memberships, better offices, private planes, and so forth). Such a
shift actually will increase the costs to the company since the pay package is
more constrained. Companies will also be less willing to hire low-wage
employees. They might avoid hiring low-wage employees by more investment
in capital or outsourcing for janitorial services, and so forth.


148. President Clinton proposed eliminating the tax deduction for all compensation
over $1 million for CEOs unless the pay is tied to company performance.
Proponents argue that this proposal will benefit shareholders. Everyone knows
that CEOs are overpaid and that their pay is not appropriately tied to performance.
This legislation helps solve both problems. Present an argument against this
proposal.

The proposal is based on the assertions that executives are both overpaid and
that their pay is not properly tied to performance. It is not obvious that
either argument is correct. The high salaries are potentially required to
attract and retain top managerial talent. CEOs to some degree are paid
based on performance (through stock ownership, etc.). Perhaps due to risk
aversion, etc., the current amount of pay-for-performance is optimal. If
salaries above $1,000,000 are required to attract and retain high quality
CEOs, the costs to companies are likely to increase if they dont change the
pay-for-performance relation because of lost tax deductions. The legislation
also would motivate companies to pay through perks (larger offices and so
forth), which would still be deductible. Shifting the manner of pay in this way
would be inefficient. The companies could respond by increasing the pay-to-
performance relation. However, if they were paying in an optimal manner
before this would also be inefficient. Also, companies might expend
resources devising ways to game the new requirements (e.g., by playing with
the definition of performance).


149. The Brown Tool Company is a multidivisional firm with offices throughout the
country. The company sets the salaries of most of its positions at the central
level. For example, secretaries are paid $8 per hour throughout the company.
Discuss two important reasons why the firm might adopt such a policy. Discuss
two important problems that the policy might cause.
Chapter 14 - Attracting And Retaining Qualified Employees

14-6


The company might set the rate centrally because it reduces agency problems
from lower-level supervisors overpaying their secretarial staffs. It also
reduces the influencing activity that would come from secretaries lobbying
their bosses for increased pay. The central company might also have better
knowledge on market rates for secretaries. On the negative side, the policy
might result in some secretaries being overpaid and other secretaries being
underpaid (if the market rates vary across different regions where the
company operates). Also paying the same rate to all employees provides little
incentive for superior performance.


1410. A recent study concluded that many employees fake sickness to avoid going to
work. The authors argue that through unwarranted sick leave, employees steal
about $150 billion a year from firms. This amount is three times larger than the
estimated loss from shoplifting. One proposal is for Congress to outlaw the
granting of sick leave to employees. The argument is that companies would be
much better off because they would not incur the giant losses associated with sick
leave. Further, the costs of taking sick leave would be internalized with the
employees. Comment on this proposal.

This proposal is a bad idea. Companies don't have to offer sick leave; it is
voluntarily included in the compensation contract. They can reasonably
forecast that some employees will fake sickness. Companies offer sick leave
because it allows them to hire employees at a lower cost than alternative pay
packages that would meet the reservation wages of employees. Thus, the law
restricts the set of feasible contracts and this is likely to increase the costs to
companies for hiring employees.


1411. The University of Rochester used to pay all faculty a 10 percent bonus as a
substitute for a retirement plan. Individuals could either place this money in a
retirement fund or keep the cash. Placing money in the fund deferred taxes on the
income until the point of withdrawal. Changes in the United States tax code
forced the university to change this policy. In particular, employees cannot be
given options of this type but must either be covered or not covered as a group.
The university now has the following policy. All new faculty members without
prior service at another university are given a 10 percent bonus in cash. This
payment is treated as ordinary income for tax purposes. Most new faculty are
young people fresh out of graduate school. All faculty members with more than 2
years of service must place the bonus in a retirement account. Taxes are deferred
until withdrawal from the account. Explain why it might make economic sense
for the university to have such a two-group plan, rather than treat all employees
(old and new) the same.

Chapter 14 - Attracting And Retaining Qualified Employees

14-7

An employee must be paid his reservation utility (the utility from his next
best alternative) to attract and retain him in his position. It is in the
organization's interests to design compensation packages that meet this
reservation utility at the lowest cost. To do this, a firm should listen to the
preferences of the employee. If an employee prefers $1,000 cash to $1,000
fringe benefits, the employer should pay the employee the cash (unless the
company derives some other benefit from paying fringe benefits). Under the
old system, employees were given complete flexibility on how to allocate the
money between retirement and cash compensation. Such a policy makes the
typical employee better off and makes it easier for the University to attract
and retain employees. Changes in the tax law precluded this policy. The
University, however, tries to mimic what people would have chosen on their
own account. Under the old system, about 35 percent of the employees took
the cash, while 65 percent invested the money in a retirement plan. The 35
percent tended to be younger employees who wanted the money for buying
houses, and investing for their childrens college education. The new
University policy tends to pay cash to young faculty and retirement for older
faculty.


1412. The University of Medford pays the full tuition for the children of faculty
members at any university in the world. Recently, this policy has received bad
publicity. The argument has been made that people in other occupations have to
pay the tuition costs for their children and so should college professors.
According to this argument, it is not fair to have these relatively well-paid people
get subsidized in this manner. The board of trustees of the University of Medford
has been asked to reconsider this policy. Provide an economic argument to
explain why the board of trustees might want to continue this policy.

Tuition benefits are a form of compensation that might be highly valued by
faculty members. Taking this benefit away lowers their pay. If the University
was paying a competitive wage rate in the first place, it will lose faculty
unless it offsets this decrease in pay with an increase in some other
component of the pay package, such as straight salary. Due to tax effects, the
University may end up paying more to attract and retain qualified faculty
than when it offered them tuition benefits.


1413. Payments under some retirement plans are based on the average earnings in the
last few years of employment. Discuss the potential incentive effects of this
policy.

Chapter 14 - Attracting And Retaining Qualified Employees

14-8

This provision might increase the incentives of employees in the last years of
their employment because the wage increases over this period are very
important in determining future retirement benefits. On the other hand, the
provision might increase the influencing activity of older employees who have
strong incentives to lobby for higher pay in their last years of employment.


1414. Companies can often gain if they listen to employees about what they prefer in the
way of a fringe benefit package a more preferred package serves to attract and
retain employees at a lower cost. Nevertheless, many firms have shunned menu
plans where each employee would be completely free to choose their own fringe
benefit package. (For instance, those wanting health insurance could buy it
through the company, whereas those who want some other benefit or cash would
make different choices.) Why do you think many firms have avoided this type of
menu plan?

There are several costs that firms face with menu plans. First, there are
adverse selection problems. For instance, a person who knows he is sick is
more likely to buy health insurance at a given price than a person who thinks
he is well. This problem can increase the costs of insurance since the
insurance company will insist on physical exam, etc. to qualify for insurance.
When everyone in the company is insured adverse selection is less of a
problem. Other costs include administrative costs for running the program
and potential lost economies from buying the fringe benefits in larger
quantities. Also, it can make it more difficult for a firm to use the fringe
benefit policy to attract a particular type of worker.


1415. The Good Beer Brewing Company currently purchases health insurance for its
10,000 employees. The company is considering a flexible plan where employees
can have either $2,000 in cash or insurance coverage (the insurance costs $2,000).
The company figures it will expend the same amount of money either way.
However, employees will be made better off because they can choose the option
that is most preferred. Do you see any potential problems with this idea? Explain.

There are at least two problems that might be mentioned.

a. The plan is likely to motivate an adverse selection problem. The
people most likely to buy insurance are those who need it the most.
The insurance company will anticipate this problem and do things
like requiring medical exams for insurance coverage. Also the
company might increase the rates to reflect the less healthy pool of
employees being covered by the insurance. Overall, the price of
insurance is likely to rise.

Chapter 14 - Attracting And Retaining Qualified Employees

14-9

b. There will be costs to administer the system. Employees must be
notified of their options. Systems must be created to track the choices
and changes in these choices.


1416. Public accounting firms have traditionally paid low starting salaries to new
employees. Nevertheless, these firms have been able to hire and retain qualified
employees (even though these employees could obtain higher salaries elsewhere).
Is this observation inconsistent with economic theory? Explain.

This observation is not inconsistent with economic theory. At least two points
could be made:

a. Employees care not only about current earnings but future earnings
as well. Employees may be willing to take a reduction in current
salaries because the training they receive will allow them to earn high
salaries in the future. Also, the firms might offer an upward sloping
earnings profile, where lower earnings at first are offset by higher
earnings later.

b. The employees might be receiving other fringe benefits that offset the
lower wages.


1417. People buying disability insurance on an individual basis are often required to
take physical exams. Physical exams are typically not required when employees
acquire disability insurance through a company-sponsored plan (which covers all
employees in the firm). Provide an economic rationale for the different policies
relating to physical exams.

There is an adverse selection problem in insurance people are likely to
have better information about their individual health than the insurance
company. Under the group plan this is less of a problem because all
employees are covered (there is limited self-selection). Thus, the insurance
company can rely on the actuarial tables, etc. to price the insurance. When
people buy on personal account they are self-selecting. Here the insurance
company must worry about less healthy people tending to be the most likely
to buy at any given price. Physical exams help to overcome the informational
asymmetry.


1418. Marks & Spencer is a large, established British retailer of apparel, housewares
and food products. The company has a large workforce. As part of the
company's benefits package, employees receive a discount of 30 percent off all
purchases of apparel.

Chapter 14 - Attracting And Retaining Qualified Employees

14-10

a. What are the advantages and disadvantages of offering a 30 percent
discount off company merchandise?

+ tax-advantage benefit (discount is invisible to taxing authority)
+ employees try merchandise and may suggest improvements
+ attracts people who like your product and will be enthusiastic
about it when discussing it with potential customers
discourages employees from trying competitors products; you
obtain less information on how your product performs vs. the
competition
adverse selection: you attract people who expect to buy a lot of
your product, and that may result in lost profits

b. What are the advantages and disadvantages of offering a 30 percent
discount off apparel, but not housewares and food products? Why do you
think the company differentiates between apparel and other products?

+ food and housewares are easier to re-sell than apparel, so
discount on food and housewares might result in black market
for your goods.
attracts people who like your apparel, but not people who like
your foods and housewares; less enthusiasm for foods and
housewares


1419. A recent study found that CEOs in Europe are paid substantially less than CEOs
in America, even after controlling for a firms size and industry. Does this
necessarily imply that American CEOs are overpaid? Explain.

No. Firms have to pay market-determined compensation packages to attract
and retain qualified CEOs. Even after controlling for firm size and industry,
the types of CEOs that American firms want to hire can vary from the types
of CEOs that European firms want to hire. Correspondingly, the markets for
the two types of CEOs can vary. Casual evidence suggests that there are
fewer interfirm transfers of CEOs in Europe than in the United States and
less market pressure on CEO compensation (although this seems to be
changing).


Chapter 14 - Attracting And Retaining Qualified Employees

14-11

1420. Consider two states that are nearly identical in terms of income, climate, and
population. There are public universities in both states. One state has a law
which specifies that all professors of a given rank (assistant, associate and full
professor) have to be paid the same. Thus an assistant professor whether in history
or in law has to be paid the same. Associate professors are paid more than
assistant professors. However, all associate professors have to be paid the same.
The same is true for full professors. The other state does not have such a law. In
this state law professors are paid substantially more than history professors within
each rank. The laws in both states allow the universities to choose their own
teaching loads for faculty. These loads can vary across faculty members.

a. How do you expect the teaching loads to vary across the two states (you
can focus on history and law departments)? Explain the economic
reasoning behind your answer.

Presumably, in the state without the law all types of professors are
being paid competitive compensation packages. Law professors are
likely to be paid more than history professors are because they are in
shorter supply relative to demand. If the law in the other state is
binding and forces the state to alter the wage rate, it will have to
adjust other elements in the professors total compensation to serve as
a compensating differential. If the law results in lower monetary
compensation for some types of professors (e.g., the higher paid law
professors), presumably the teaching loads will be reduced. Otherwise
the professors will seek jobs in other states. Alternatively, if the law
makes the state pay more for certain types of professors (e.g., history
professors), they can be asked to teach more classes without quitting
and moving to the other state.

b. Are either history or law professors in the state with the law necessarily
better or worse off than their counterparts in the state without the law?
Explain.

No. With compensating differentials all may be paid their reservation
utility.

c. Discuss how the residents of the state might be made worse off by such a
law.

Chapter 14 - Attracting And Retaining Qualified Employees

14-12

It may be inefficient to make up for the differences in monetary
compensation by adjusting teaching loads (e.g., due to fixed costs of
hiring additional faculty to cover the reduced courses, a course
reduction may cost the state $10,000 but only be valued by the
professor at $8,000). These costs will be borne by taxpayers (assuming
the professor is paid his/her reservation wage in any case). Also, to the
extent the laws make hiring professors more expensive, the state
might respond by hiring fewer professors or lower quality professors.
In either case the residents of the state might be worse off.


1421. Some companies base promotions solely on seniority. Discuss the negative and
positive aspects of such a policy.

Positives: Reduces influence costs since there is less reason to try to convince
a manager that you are the right person for the promotion.

Negatives: Reduces incentives to work hard and may result in less skilled
people being promoted.


14-22. Building on the discussion in Chapter 3 on minimum wage laws, how would you
expect a large increase in the minimum wage to affect the pay package (mix
between salary and benefits) offered by employers?

An increase in the minimum wage should cause employers to reduce the
fringe benefits component of the pack package.