>[!question] If you end up paying straight salary with modest merit adjustments, how do firms motivate performance? # Pay by Hierarchical Level Pay per hierarchical level increases. The slope of the increase also increases (greater difference between levels 6 & 7 than between levels 1 & 2) The variance of pay also increases as hierarchical level increases. - Most low-level employees are paid very similarly - Higher-level employee pay can vary significantly # Promotion Rules >[!question] Tournament or Standard? ## Tournament Extreme version: Promote all or none whose performance matches some standard - Advantage: Quality of promoted employees is better controlled - Disadvantage: The number of employees promoted is variable and difficult to control ## Standard Extreme version: Promote a fixed number of the best performers, regardless of performance - Advantage: Number of employees promoted is dictated - Disadvantage: Quality of employees promoted is variable - If everyone sucks, then the person you are now promoting will suck **Key Feature**: Relative Performance Evaluation - Reward is "all-or-nothing", so the evaluation is also *ordinal* - **only** ranking matters - Indicates that an employee can output almost nothing, but as long as they are better than the next one, they will be promoted. # Relative vs Absolute Performance Evaluation >[!question] How easy can performance be measured? ## Uncontrollable Risks Example: Two salespeople, in Denmark & Singapore - Performance - depends on effort ($e$), plus good or bad luck from business conditions locally ($\epsilon$) and globally ($n$) - Global conditions affect both identically - Local conditions affect each individually![[econ447_risks.png]] >[!question] Which measure is less risky? - Individual evaluation is better if idiosyncratic risk is stronger - Relative evaluation is better if common/shared risk ($n$) is stronger. - $n$ might be global economic conditions ## Incentive Manipulation ### Sabatoge - An employee can improve his/her ranking by putting forth more effort into the job and achieving better performance - An employee can **also** increase his/her own ranking by lowering others' ranking - Sabotage can improve an individual employee's relative performance evaluation at the expense of **both** the other employee and the firm - Relative Performance Evaluation reduces incentives for workers to cooperate on the job #### Potential Remedies - Incorporate measures of cooperation and sabotage into performance evaluation - Catch is that these can be very difficult to catch and quantify - Broader performance measure - Reduces sabotage incentive, but increases risk (braindead teammate) - When cooperation is important, reduce the use of and awards based on RPE # Promotion and Incentives ## Effort, Evaluation, and Rewards $ \frac{\Delta Pay}{\Delta Effort}=\frac{\Delta Pay}{\Delta PM}\times\frac{\Delta PM}{\Delta Effort} $ $\Delta PM$ Cancels out The reward of the promotion is largely the immediate wage raise $\Delta W$. - If a promotion is guaranteed, there is no incentive - If a promotion is impossible, there is no incentive - Strongest incentives generally occur (for any lump-sum award) when the odds of winning are closest to 50% Compensation at higher levels affects incentives at lower levels (Next promotion is contingent on previous ones, and employees want to work up the "ladder") ## Tournament Theory >[!info] A theory that explains wage structure in organizations: When employees' efforts and outputs are difficult to measure and monitoring is costly, wage differences may not be based on marginal productivity but instead upon relative differences between the individuals ### Tournament Theory Predicts - Larger prizes motivate more effort and better performance - A greater effect of extra effort on the change of winning brings greater motivation - Pay grows in a convex manner with hierarchical level # Internal vs External Hiring ## Outside/External Hiring - External hires get paid more on average, but have lower performance ### Pros - Ensure quality - Bring in specific skills needed by the firm - Reduce sabatoge - Increase internal productivity when facing external competition ### Cons - Information asymmetry ("Winner's curse") - Outsiders lack firm-specific knowledge and skills - Lower incentives for internal candidates ## Internal Hiring - Career ladders - Greater incentive for internal employees - Employees already have firm-specific knowledge