Question:
You are hired by the Fair Work Commission Australia as a consultant to examine Issues relating to pay and Performance. Your task is to provide a report detailing findings from the economic literature on the effectiveness of pay for performance, and how performance should be evaluated based on Incentive pay.
Employment is one of the most crucial issues of concern in every economy in the world. Employment structures prevailing in the economy contributes significantly in determining the standard of living, over all well being of the resident of the country and the overall economic growth of the same. Therefore, it is of utmost importance to study about the key factors, which influence the employment sector of any economy, both, private as well as public (Meer & West, 2015). One of such primary factors is the wage structure which prevails in the firms of an economy at a particular period of time as a significant share of the behavior of the workers and their willingness to work depend on the wage which they are getting which in turn also determine their overall economic well being and lifestyle.
The wage structure prevailing in a firm also determines the productivity, prospects and the long run profitability of the firm as much of the prospects of a firm is related to the employees working in the firm and how loyal and willing to work they are. In this report, the aspect of wage structure will be taken into account, emphasizing on the issues related to pay for performance model (Fang & Gerhart, 2012). The report aims to study the literatures present regarding this issue and its effectiveness, keeping into account the economic concept of Efficiency Wages and its implications on the performance of the workers. It also tries to analyze the basis of evaluation of the performance of the workers based on the incentives in payment, which they get in their jobs.
There have been extensive assertions regarding the benefit of an equitable wage structure in the economy as the proponents of this theory suggests that equity in wage distribution ensures greater welfare of the people in the workforce in general. However, there are opinions against this theory as many of the contemporary economists and business planners propose a model of pay for performance. According to this model, a part of the incentives or wage structure of the employees should be determined by the level of productivity and performance of the employees. This, as asserted by them, gives the able employees to work more and increases their willingness to be productive and competitive in a fair way, which in turn may lead to an increased efficiency in the productive activities of the firms. This scope, however, is absent in the equitable wage theory (Dunlop & Segrave, 2016).
This theory of pay for performance is related to the economic concept of efficiency wage, which suggests that it may be beneficial for the firms to pay a higher wage to their workers. According to this theory, that can increase their loyalty, devotion and willingness to produce and therefore can increase the efficiency of the workers and the firms as a whole in the long run.
However, there are debates regarding whether efficiency wage theory or the notion of pay for performance are actually profitable for the firms and if so till what extent the wages should be increased such that it increases the productivity of the workers without having any negative implications on the firms’ profit and prospects. The economic concept of the backward bending labor supply curve is similar to this notion (Thuy & Flaaten, 2013). This theory suggests that there is a tradeoff between the labor hours and the time for leisure for the workers and if wages are increased above a certain level the willingness of the workers to work more actually reduces as the workers tend to substitute labor hours with more leisure.
There are extensive literary works related to the different theories, propositions and counter propositions prevailing regarding the wage structure and the viability of the efficiency wage theories and pay for performance concept, which are discussed in the following section.
Wage structure and differences in the same across geographical locations and with time have been issues of key concern as they have direct implications on the economic well being of people and a region as a whole. Over the years, with changes in the dynamics of the employment structure in the global framework, the wage structures of the firms have also undergone significant modifications to adapt with changing time. Several wage theories and models exist in the economy, which tries to propose different wage structures and also tries to explain their viability in the contemporary global employment scenario.
Lavoie & Stockhammer, (2013), have put the advantages of an equitable distribution of wages forward. They assert that much of the existing inequalities and poverty related issues in the contemporary world can be attributed to the consistently increasing gaps in the wage structure of the labor force. The differences are mainly occurring due to dissimilarities in the nature of the jobs they are doing, the firms in which they are employed and the economic structure and overall societal and developmental patterns of the countries in which they are working (Leigh & Blakely, 2016). According to the authors, the inequalities can be reduced by designing a more equitable wage distribution on part of the firms in the global economy. However, their propositions have been criticized on the ground of efficiency and overall productivity of the firms.
Mueller, Ouimet & Simintzi, (2015) in their works, have tried to focus on the different wage theories, which exist in the contemporary economy. They try to counter the theory of equitable wage distribution. According to the authors, though the theory, discussed prior, apparently seems to be appealing in terms of overall societal welfare, in the real global employment scenario, there exits inequality in the distribution of wages and in many cases, there are logical and rightful reasons for the existence of such inequality in the wages of the workers. As per the arguments put forward by the authors, often there are inequality in the wage structure of the firms, which may be actually beneficial for the firms as well as the objectives of the workers, depending upon the structure of wage differences and the purpose for which they exist (Stewart, 2012). The authors also point out there several trends of inequality, which are very common in the international employment scenario.
Wages for the routine jobs, which are more mechanical in nature, are comparatively less than the wages of those jobs in which there are more challenges and requirement for skills. The entry level wages offered by the large and more prospective firms, as argued by the authors, are generally less than the same offered in the start ups. Often this is done because the larger firms in exchange offer better career prospects for the workers and the employees often take the low paid jobs for getting this opportunity and in such cases, the inequalities do not hurt the workers.
One of the major arguments in favor of ethical inequality in wages is the pay for performance model (Frey, Homberg & Osterloh, 2013). This wage structure, by providing opportunities to earn more by working more, gives incentives to the workers to increase their productivity, skills and willingness to work more, which in turn increases the overall productivity of the firms in the long run. There are many literatures supporting the pay for performance model as according to these literatures, this actually motivates the workers to excel in their works and the inequality, which is created by this structure, is because of the differences in the individual abilities of the workers and their willingness to trade off leisure for earning more by working more. This model is to a considerable extent similar to the economic concept of the efficiency wage theory, which is discussed, in the following sector, taking reference of the eminent literary works present in the contemporary economic scenario.
As suggested by DiGabriele & Ojo, (2017), the efficiency wage mechanism includes the practice of keeping the wage above the equilibrium market level, which in turn results in greater efficiency, even in the presence of surplus labor in the concerned country. The authors suggest that that along with labor union and minimum wage criterion, the presence of efficiency wage model also contributes to the unemployment in the country because all the three advocates for keeping the wages of the workers above the equilibrium level. However, the efficiency wage theory differs from the other two notions in the way that the latter two requires restrictions to be imposed on the firms whereas in the former does not require any restrictions and the firms do this to increase their own profitability.
There are several arguments in favor of the efficiency wage theory, which shows the positive implications of higher wages on the improvement of the efficiency of the workers:
One of the primary costs incurred by the firms, which also negatively contribute to the growth aspects of the firms as well as to the economic well being of the workers is the issue of turnover of the workers from the firms. As put forward by Weiss, (2014), there are direct relations between the turnover of the labor and the wages received by the labors. The turnovers are generally higher in those firms or industries in which there are not sufficient incentives, financial and others, for the workers in their existing jobs. The workers in general always have a cost benefit approach in deciding to stay in a job or leave. If there are sufficient incentives for good performance in any industry, then the turnovers are usually less, as the workers feel more loyal and motivated to do better, which in turn increases their monetary benefits and the long run prospects of the firms (Keeley, 2013).
Health of the workers
Some theories directly relate the wages received by the labors with their health conditions. Higher wages result in a more healthy diet for the workers, which in turn increases their health and productivity conditions and thus it may be preferable for the firms because a healthy, productive and loyal workforce increases the overall productivity and efficiency of the firms in the long run (Moore & Viscusi, 2014). However, the author also points out the limitations of this proposition as diet and health are not that much related with the wage rates in the highly developed countries because the minimum wage levels in these countries usually are inclusive of all these facilities.
Kwon, (2014), in his works, tries to relate the connectivity of the efforts given by the workers with the wages and incentives received by them. According to the author, in places where the nature of the jobs allows the workers to decide how much effort they want to give, presence of proper performance based incentives are necessary as in the absence of the same, the workers would lose the incentive to work hard. However, with higher wages and performance-based incentives, the workers feel motivated and the problem of shirking is to some extent solved.
Fabris (2013), shows the relation between the effort given by the workers and the wage they receive in a mathematical form. According to the author, the effort of the workers mainly depends on two factors, the relative wage the workers receive in the firm and the overall level of unemployment prevailing in the economy. The relation can be mathematically shown as follows:
Ei = f(Wi/We, U), where, Wi is the wage the worker receive in the firm in which he is working,
U is the level of unemployment prevailing in the economy
Therefore, Wi/We shows the relative wage prevailing in the firm and if it increases then the effort given by the workers also increases, as per the propositions of this theory.
From the above-discussed perspectives regarding the positive aspects of the existence of the efficiency wage proposition, it is evident that there are substantial support in favor of the efficiency wage theory and many of these points towards the efficiency and productivity aspects of the firms in the long run. However, there have been substantial debates regarding the applicability of this model, as there are several arguments against the model.
The relation between the supply of labor and the wage rates existing is shown with the help of the labor supply curve. In an ideal world, labor is supposed to increase continually with the increase in the wage of the labor. However, as asserted by Wachtel (2013), in real case scenarios, the labor supply curve is not only dependant on the wage rate existing in the economy but also on the tradeoff between labor and leisure of the workers and their individual preferences. The author asserts that if the wages go on increasing continuously, then initially with the increase in the wage the workers will feel motivated to increase their working hours and work more, which may benefit the firms. However, after reaching a point, if the wages still go on rising, then the workers will tend to increase their leisure and for that they may also be ready to sacrifice a few labor hours as they are already earning higher wages.
Figure 1: Backward bending supply curve of labor
(Source: Mankiw, 2014)
As can be seen from the above diagram, after reaching a certain wage level, the substitution effect of the increase in the wage of the labor becomes greater than the income effect of the same and therefore, the labors tend to substitute their labor hours with leisure hours. This theory therefore, challenges the pay for performance and the efficiency wage theories to some extent as according to this theory continuous increase in the wage rate may actually lead to a fall in the level of willingness to work on part of the workers.
In the above sections, two contradicting theories of the efficiency wages and the backward bending supply curve of labor are discussed in details. These two theories, however, need empirical evidences to support their viability and applicability in the real labor scenario in the international framework. The primary questions, which arise in this aspect, are firstly whether a positive link is associated between the unemployment and wage rate and secondly whether efficiency wage increases the labor productivity and the output of the firms.
However, when it comes to Australia, McLachlan (2013), suggests that the hypothesis of efficiency wage does not have robust evidences in the country and the relation between unemployment and wage is also not proved as per the evidences that can be seen from the finding of the paper. The author links this weakness with the fluctuations in the business cycle in the industry.
There are studies regarding the relationship between wage and motivation in the public sector of different countries. Taylor & Taylor (2012), in their analysis took 15 countries in consideration and their studies show that there is lack of motivation in the public sector than in the private sector, even by monetary rewards. The study also shows that where the elasticity of effort with respect to wage is 0.21, the elasticity of motivation with respect to effort in the public sector is 0.61. However, the findings of Kumar, Webber and Perry (2012), finds that with one percent increase in wage is Australian manufacturing sector, the productivity increases from 0.5 percent to 0.8 percent.
Conclusion
As can be seen from the above discussion, there are several theories, which assert the importance of higher wage or efficiency wage in increasing the efforts and willingness of the workers and thereby increasing the productivity of the firms. From the empirical evidences its seen that there is a significant positive relationship between the higher wage and more productivity in the manufacturing sector of Australia. As per the literature, it can be concluded that efficiency wage is a viable tool to increase productivity, though in some cases, like that in the public sector, motivation works more effectively that increase in the wages to increase the productivity in Australia.
References
DiGabriele, J., & Ojo, M. (2017). The efficiency wage hypothesis and the role of corporate governance in firm performance.
Dunlop, J., & Segrave, M. (2016). The theory of wage determination. Springer.
Fabris, N. (2013). Efficiency-wage model. Sociologija, 55(3), 461-474.
Fang, M., & Gerhart, B. (2012). Does pay for performance diminish intrinsic interest?. The International Journal of Human Resource Management, 23(6), 1176-1196.
Frey, B. S., Homberg, F., & Osterloh, M. (2013). Organizational control systems and pay-for-performance in the public service. Organization Studies, 34(7), 949-972.
Keeley, M. C. (2013). Labor supply and public policy: A critical review. Elsevier.
Kumar, S., Webber, D. J., & Perry, G. (2012). Real wages, inflation and labour productivity in Australia. Applied Economics, 44(23), 2945-2954.
Kwon, H. S. (2014). Economic theories of low-wage work. Journal of Human Behavior in the Social Environment, 24(1), 61-70.
Lavoie, M., & Stockhammer, E. (2013). Wage-led growth: Concept, theories and policies. In Wage-led Growth (pp. 13-39). Palgrave Macmillan UK.
Leigh, N. G., & Blakely, E. J. (2016). Planning local economic development: Theory and practice. Sage Publications.
Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.
McLachlan, R. (2013). Deep and Persistent Disadvantage in Australia-Productivity Commission Staff Working Paper.
Meer, J., & West, J. (2015). Effects of the minimum wage on employment dynamics. Journal of Human Resources.
Moore, M. J., & Viscusi, W. K. (2014). Compensation mechanisms for job risks: wages, Workers’ Compensation, and product liability. Princeton University Press.
Mueller, H. M., Ouimet, P. P., & Simintzi, E. (2015). Wage inequality and firm growth (No. w20876). National Bureau of Economic Research.
Stewart, M. B. (2012). Wage inequality, minimum wage effects, and spillovers. Oxford Economic Papers, 64(4), 616-634.
Taylor, J., & Taylor, R. (2011). Working hard for more money or working hard to make a difference? Efficiency wages, public service motivation, and effort. Review of Public Personnel Administration, 31(1), 67-86.
Thuy, P. T. T., & Flaaten, O. (2013). The backward-bending supply curve in fisheries-revisited. Journal of Sustainable Development, 6(6), 15.
Wachtel, H. M. (2013). Labor and the Economy. Elsevier.
Weiss, A. (2014). Efficiency wages: Models of unemployment, layoffs, and wage dispersion. Princeton University Press.
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