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Edward Lazear, founder of Personnel Economics.

Principal-Agent Framework

The Principal-Agent Framework is based on the relationship between an employer (principal) and an employee (agent). In this case, the employer relies on their employees to maximize the firm’s utility. In practice, incentives are sometimes misaligned between the principal and the agent. This occurs due to differing goals between the two, this can lead to adverse selection for the principal when hiring an agent, they cannot fully evaluate an agent's skills and moral hazard for the agent when presented with more information than the principal.

Approaches to resolving conflict

1. Fixed payment with monitoring
   • Fixed salaries are provided to agents while their performance is under observation.
   • Disadvantages: Shirking, monitoring costs and adverse selection.
     • Shirking: No incentive to act in the best interest of the principal/firm because the agent is guaranteed pay.
     • Monitoring Costs: Additional resources and costs to monitor and measure agent performance.
     • Adverse Selection: Agents will look elsewhere for a job where performance is not as heavily monitored.
2. Incentive pay without monitoring
   • Payment is correlated with output and performance is not monitored.
   • Disadvantages: Inequitable pay and compensation
     • Inequitable Pay: Prone to delays and interruptions, and unreasonable to punish agents for these issues.
     • Compensation: Principals may have to provide agents a risk premium as agents bear a risk with payment.

Tournament Theory (Promotions and Raises)

Tournament Theory was proposed by Edward Lazear and Sherwin Rosen (citation). The theory addresses how pay raises are associated with promotions. The theory’s main point is that promotions are a relative gain. Regarding compensation, the level of compensation must be strong enough to motivate all employees below the level of compensation who aim to be promoted. If the pay spread between promotions is larger, the incentive of employees to put in effort will also be larger. The desired outcome from this would be to see employees performing at a quality and producing a quantity of output that the organization deems desirable. Compensation is also not necessarily determined by the conception of productivity. Employees are promoted based on their relative position within the organization and not by their productivity. However, productivity does hold some weight when considering promotion.

Advantages vs Disadvantages

Incentive Performance: Workplaces that promote competition among employees may benefit from incentivized performance. Studies have shown that competition within the workplace helps boost performance because employees value the idea of being better than the rest.

Matching Workers and Jobs: Under Tournament Theory, workers are matched to their appropriate job. Firms with a tournament structure in the workplace are more likely to hire more competitive and highly-skilled workers, and firms with a workplace based structured around equity are more likely to hire less competitive and lower-skilled workers.

Inequality within the Workplace: Workplaces that are based around a tournament structure are prone to creating an unequal working environment. If workers are paid based on their performance, it has the potential to leave some employees worse off than others. This type environment could also be more demotivating for under-performing workers and more motivating for over-achieving workers which results in a bigger payoff gap between the two types of workers over time.

Unethical Behavior: A problem with competition in a workplace is that it is prone to promoting unethical behavior within employees. As they are competing against each other, they may succumb to inappropriate actions that can hurt another employee's standing within the company.

Pay Compression

Pay compression, a compensation issue where wage or salary levels are non-distinguishable between long-term employees and newly hired employees. This issue develops over time, and if no action is taken to resolve this issue, organizations run a risk of a turnover. Long-term employees will feel they are undervalued and will look for work elsewhere. However, a certain degree of pay compression may lead to an efficient market outcome.

Organizations with more of a team-based work environment could consider a certain degree of pay compression. Pay compression in this case would make equity more relevant in close comparisons. It can also help boost morale and worker efficiency but may lead to high productive workers leaving to join a competitor organization with a higher wage or salary. It also helps insure employees during uncertain outcomes, such as bad market conditions. However, this leaves employees vulnerable to moral hazard problems and they may put less effort into their work.

Working alongside the Tournament Theory, employees may improve their image not only by making themselves look better, but also by making their rivals look worse. Having pay being based on relative performance may cause some issues within the workplace. Co-workers will be less likely to cooperate with each other knowing that there is an opportunity to outshine each other. Pay compression can help in this case by closing the salary gap between job levels. Which in turn gives less incentive for employees to sabotage their co-workers.

Hedonic Model of Compensation

The Hedonic Model is a revealed preference method used to estimate the demand or value of a good to a consumer. In the case of Personnel Economics, the model is used to estimate the value of compensation for a worker. Employees care more than just their wage or salary; they care for things outside of money. Such as:

• Flexible work hours
• Comfortable and enjoyable working environment
• Health insurance and pension benefits
• Recognition and mentoring from bosses

Preferences show that older workers tend to favor health insurance or pension benefits than younger workers. The Hedonic Model of Compensation helps firms to solve the balance between costs and benefits, with the goal to offer the best mixed package of pay and benefits to entice workers. The final package is determined by the preferences of the employees, the cost structure of the firm, and the desire to hire employees.

The Hedonic Model has several predictions:

1. There is a negative trade-off between wages and “positive” job attributes.
2. Each firm offers the benefits that attracts their most valued type of worker.

These benefits are costly for a firm, but they are also helpful by boosting productivity.

Team Production

Over time, more firms have adopted team production instead of pursuing individual production. There are advantages and disadvantages to adopting team production. Team production can be more productive than individual protection, work can be distributed between employees based on each of their specific skill sets. It may be more efficient than leaving all the work to one sole individual. However, there are also disadvantages with team production. The time it takes to organize teams and have them cooperate can be time consuming. There is also the potential risk of having a free-rider problem, individuals within a team can get away with no contribution to the work and still be compensated the same amount as their peers. However, the free-rider problem can be eliminated. One solution is by organizing set protocols, this allows for easier communication and decision-making. This gives each member of the team responsibilities and requirements that are agreed upon. Punishing free-riders is another way to deter them from repeating the offense. Even though free-riding is an issue when working as a team, the benefits may outweigh the potential disadvantages:

• Many projects require a wide variety of skill sets, one individual is not likely to have all the required skills to complete the project by themselves. If members of the team have complementary skill sets, they will be able to benefit off each other allowing for more efficiency in the project.
• Teamwork offers different perspectives, each member may have a different way on how to handle the project. By sharing ideas, teams can produce a better quality work than if the project was done by an individual.
• Easier for firms to hire people with less skills, each specializing in a few skills than hiring an individual with a wide variety of skills. Individuals with a high skill set are also more expensive to hire.
• It is unlikely that one individual will have an absolute advantage over everyone else, hence it may be better to split tasks among a group instead.

Depending on the skill sets of individuals within a firm, the firm will choose between a team-based work environment or a hierarchical based work environment. Team production would be more beneficial if no individuals within a firm have an absolute advantage over their peers. Hierarchical would be more beneficial if there are individuals within a firm with an absolute advantage over their peers.

Human Resource Management Practices

The human resource practices that firms adopt have been changing to allow for more incentive pay and with a bigger focus on teamwork. Although not all firms have experienced success with these new changes. When introducing a new practice, it is important to have other practices alongside to increase the chance of success and the outcome. Firms run the risk of not reaching optimal output if they choose not to run all practices. Economists and non-economists acknowledge the important value of complementary practices, human resource practices can be viewed as complements as the more that are implemented, the more effective the other practices become. This is important for when firms consider practices such as teamwork and incentive pay, they would need to consider the value of a set of practices over an individual practice.

Studies have shown the effectiveness of adopting a system of complementary practices rather than individual-based practices. Ichniowski, Shaw, and Prennushi (1997) found that steel mills that used a complementary set of practices were substantially more productive compared to their counterparts that used a limited set.

In human resource management, there are two types of practices that organizations use, skill-enhancing practices and motivation-enhancing practices.

List of motivation-enhancing practices that are used in human resource:

• Performance pay (enhancing) vs Fixed pay (motivation)
  • Performance Pay: Pay based on the performance of the worker.
  • Fixed Pay: Pay that is fixed for all workers.
• Close supervision (enhancing) vs Freedom and trust (motivation)
  • Close Supervision: Work is monitored and closely reviewed.
  • Freedom and Trust: Workers are less monitored and have more freedom
• Reward seniority (motivation) vs Reward performance (enhancing)
  • Reward Seniority: Benefits for staying with a company in the long-term.
  • Reward Performance: Rewarded on the basis of performance, similar to performance pay.
• Job security (motivation) vs Competitive selection (enhancing)
  • Job Security: Insured a secure long-term job regardless of performance.
  • Competitive Selection: Workers compete for jobs, under-performing workers are likely to be let go and over-achieving workers stay.
• Intrinsic motivation (motivation) vs Extrinsic rewards (enhancing)
  • Intrinsic Motivation: Appreciation of the work employees produce, motivating them to work harder.
  • Extrinsic Rewards: Monetary rewards for producing high quality work.
• Benefits and entitlements (motivation) vs Additional pay (enhancing)
  • Benefits and Entitlements: Compensation in the form of non-monetary payment, e.g., insurance, pension, etc.
  • Additional Pay: Compensation in the form of monetary payment.