1: Hiring new employees

Suppose: there are two candidates to fill a position, one has a predictable outcome and the other an unpredictable outcome (i.e. it is possible that he performs better or worse than the other candidate). If the expected outcome of both candidates is the same, it is better to choose for the riskier candidate. This is because the firm can keep him if it turns out that he is a good employee and fire him if it turns out that he is a bad employee.

There are several factors that are important to think of when deciding whether or not to take the risk:

• Downside risk: The higher the potential that the employee can destroy value, the less likely it is to take the risk and hire the riskier candidate.
• Upside potential: The greater the profits when the candidate turns out to be a good choice, the more likely it is to hire the riskier candidate.
• Termination costs: The more it costs to fire an employee, the more it costs to hire the riskier candidate when it turns out that he is a bad employee. However, it can still be more profitable to hire the riskier candidate.
• Risk aversion: The greater the risk aversion of the firm, the more it costs the firm to hire the riskier candidate. But it can still be more profitable to hire the riskier candidate if the expected extra productivity compensates for the risk aversion.
• Length of evaluation: The time that is needed to see if the chosen candidate is a good employee or not. The sooner this is visible, the more attractive to hire the riskier candidate.
• Length of employment: Hiring a risky candidate is more attractive if the candidate is younger and, therefore, likely to stay longer in the organization.

Note: it is likely that when an employee turns out to be really good, competitors will also be interested in hiring that employee. If his productivity in their company is likely to be the same as in your firm, they will make him an offer that equals his productivity. When this is the case it is not profitable to hire a risky candidate, because if he turns out to be a bad employee you lose the difference between his productivity and that of the predictable candidate (that is higher). However, when he turns out to be a good employee, you have to offer him a wage that is the same as his productivity or other firms will make him a better offer. In this situation, hiring a risky candidate is not profitable at all.

There are two possibilities, which make the hiring the riskier candidate profitable:

1. Asymmetric information: if competing firms cannot immediately see what the productivity of the new employee is.
2. Firm specific productivity: the productivity of the new employee may be higher at your firm than at another firm. When he performs well in your firm, it does not mean that he will also perform well somewhere else.

Hiring decisions

Tradeoff between costs and benefits

When you have to choose who to hire you have to look at the tradeoff between costs and benefits. Calculate who has the lowest cost per unit of output, and hire enough of this type of worker to reach the desired level of output.

Also, look always for the best alternative. In some cases it can be profitable to hire one type of worker, but hiring another type can just be more profitable.

Foreign labor

People are often afraid that companies in low labor cost countries will drive out companies in high labor cost countries. However, it does not matter if labor is cheap, it should be cost effective; it is important to look at the cost per unit of output.

Production methods

Above, the productivity of workers is independent of others. Below, three production methods will be discussed, which also include dependency.

1. Employee’s productivity is independent of coworkers: The productivity of an employee depends on his own ability and effort. In this case it is good to hire the candidate with the lowest cost per unit of output.
2. Employee’s productivity depends on coworkers: The productivity of an employee depends on the productivity of others. For example: A college student produces 100 & A HS student produces 50 - Together in a team they produce respectively 90 and 80. Because college students and HS student are more productive if they work together in teams, the firm wants to balance the amount of both.
3. Employee’s productivity depends on coworkers: A firm should improve the quality of workers that it employs as it increases the amount or the quality of its capital stock. For example, because high qualified workers use the machines more efficiently. The optimal level of skill rises as the use of capital relative to labor increases. So, do not waste the capital by placing it under the responsibility of a low-skilled individual.

A firm should hire new employees as long as the incremental profit from hiring an extra worker is positive. There is a limit to the amount of employees that a firm should hire because of the principle of diminishing marginal productivity. The more employees added to the firm, the value of an additional employee decreases. This is because employees make use of other resources, for example machines and supervision. The more employees, the less time on the machines and the less supervision each will get, which reduces their productivity. A firm should hire extra employees till the point that it is no longer profitable; this is when the marginal productivity is less or equal to the marginal labor costs.

Availability of the employees

There are a lot of differences between employees; from some sorts there are more than others. Should a firm have a bias towards the employees that are with more, because that makes them cheaper? Most organizations do not.

However, there are two situations where the firm should prefer this type of worker:

1. If a firm employs a large fraction of the local labor force. Hiring a lot of the same type drives up their wages.
2. When the ‘wanted’ type is very specific the search cost to find these employees may be quite high.

The financial situation of the organization

If a firm has a financial problem, it should try to arrange financing that can cover the short term cash flow problems. This should be done to ensure that the firm can hire new employees when it is profitable to do so. By doing this, in the long term the firm will be more likely to be able to pay his debts.

Decision making with imperfect information

Until now, we assumed that all data was available. Unfortunately, in reality the information is often not (immediately) available. There are three possibilities that occur in such a situation:

1. Make a decision independent of analysis: simply guess or make use of your instinct or experience. This approach is often least effective.

2. Estimate the required information: estimate what the required data will look like and make your decision based on these estimations.

3. Experiment: create the setting/situation yourself and measure the results of this experiment.

2: Recruiting new employees

Screening

Adverse selection = the problem of the wrong type of applicant applying to the firm. Adverse selection occurs because of asymmetric information. One party (the job candidate) knows what type of employee he is, but the other party (the employer) does not know this. In this case, the job candidate can use his information in such a way that it creates personal advantage.

Several approaches can be used to reduce the problem of adverse selection in recruiting new employees.

• Look at the CV of job candidates for credentials that distinguish that candidate from others. Important credentials could be education and experience. Credentials are useful to use for hiring under the following circumstances.

• The ability to obtain the credential must be positively correlated with the ability to perform well on the job

• Credentials should be relatively ease to obtain for well-qualified workers, compared to poorly qualified workers. Because in this case the credential is a good sign for ability.

• If differences in wages between candidates with credentials and those with no credentials are small, small differences in credentials will signal large differences in ability. Only those who are very talented will be motivated to get these credentials, since for these people the cost to get the credentials are the lowest.

• Learn more about the productivity of the job applicant: after selecting several resumes on their credentials, you can simply hire at random. However, it is better to screen all the alternatives better. This can be done by giving them tests, psychological profiling, interviews etc.

There are a few issues to consider before screening:

• Screening is more profitable when the test is more effective. More effective could mean cheaper, more accurate, or more discriminating between good and bad candidates.

• Screening is more profitable when the stakes are higher. The higher the downside risk, the higher the value of screening.

• Probation: the only way to really know whether the job candidate is good is to hire an employee for a probationary period (i.e. actually having the candidate perform the job).

For who is screening profitable

• Firm:

• Screening ensures that the productivity is higher than with random employee selection.

• However, the labor market will value screened employees as well. Therefore, there is a chance that other firms provide screened employees with a higher bid. In order to retain carefully screened employees, the firm will also have to increase wages and maybe even pay as much as their productivity. Obviously, this decreases the benefits of screening.

• Job candidates:

• In order to be willing to undergo the screening process, employees who pass the screen will want compensation for the trouble and risk involved; especially when the screening is extensive.

• When the firm cannot benefit from the screening due to competitive labor markets, job applicants will have to pay for the screening themselves; e.g. education as screening.

• Employees can implicitly pay for screening by accepting lower wages during the screening phase (see below).

In any case, both the employee and the firm will pay for and have the benefits of the screening process. Firms will pay more because screening makes their employees more profitable and because applicants require a compensation for the risk.

Besides that, highly qualified applicants are more willing to partly invest in the screening process, since they have more chance of passing the screen gain from it later.

Signaling

If employees would be honest about their skills, experience etc., and only apply for jobs that fits their ability, it would be easy for recruiters to recruit the best employees for the job. But because better employees earn more money, even less skilled employees would apply. Therefore, some kind of screening is necessary.

To attract the good type of employees:

• To deter applicants from applying, you should pay less than their alternative before probation.

• To attract some applicants for applying, you should pay more than their alternative after probation.

In this way a probation period can solve the adverse selection problem. After probation, the employees should be rigorous evaluated before they are promoted, to ensure that the good type of employees stays in the organization.

Signaling is the method that is used to solve the adverse selection problem. If low ability types are not willing to incur the cost (lower salary before probation and risk that they will not get promoted), and high ability types are willing, than the signaling is effective. That someone incurs the cost proves that they are of high quality, because they expected themselves to promote, and gain a higher wage in the long term.

An important example of signaling is education. Assume that employees do not learn the necessary thing on school. But a high skilled person is more able to learn the learning material quickly. Therefore, for a high skilled person the costs of school are less than for a low skilled person, and therefore is it likely that these high skilled persons will get high levels of education easier. If this is the case, a firm can signal high skilled employees by investing in more educated employees.

There is an evidence that education is used as signaling. Because employees who almost passed their degree earn less than employees who completed their degree. This difference is wage cannot only be explained by their differences in skills, because the learning between these two points is almost nothing. So this implies that signaling on education is used in firms.

Signaling is especially useful in the following situations:

• When employers do not have enough information about the candidates to make an accurate choice. This is especially the case for employees who are new on the labor market.

• When the differences between the candidates matter a lot for their performance. For jobs were skills are very important.

3: Skills

Matching: because there are huge differences between different firms in business, culture etc., the same employee will not be equally productive in different organizations. Therefore, it is important that good matches are made. The matching between firm and employees should be based on whether the employee’s attributes match with the attributes of the firm/job, or not. What is meant with attributes is, besides skills, also for example also about personality and preferences.

The result of matching is that there is a high turnover early in the career of employees, when the matching is done and the relationship is tested. And later in the career the turnover is low, because those who stay longer fit well with the firm. The variance in matching is higher with outside candidates than with internal candidates. This is because internal candidates have in general a better match with the firm, because they already passed the screening.

Education

Investments in training and education can be modeled in the same way as any other kind of investment. These investments analysis are called the human capital theory. The two most important forms of human capital are education and on the job training.

Investments are made if the present value of the benefits that are generated by the investment exceeds the present value of the costs that are associated with the investment. Here, we focus only on earnings as benefits of investments. But there are also other important benefits; investments on education can make you more effective at home, or you can just enjoy the learning.

The present value of the return on education can be calculated with the following formula:

                                                                  T    K(t) – H(t)

Present value of return on investment=   ∑    --------------

                                                                T=1    (1+r)^t

K= earnings after investment

H= earnings when investment is not made

r= interest rate per year

t = time in years

T= last year of career

But there are also costs associated with the investments in education. There are two types of these costs.

• Direct costs. These are borne up front and are costs as textbooks, supplies etc. Direct costs are denoted by C(0).

• Opportunity costs for the time that is spent on the education. These opportunity costs are for example the amount of money that could be earned if they should work instead of studying. Opportunity costs are denoted by F(0).

The total costs of investments are direct costs + opportunity costs and therefore C(0) + F(0).

If we take the net present value of the costs of the investment and the present value of the returns on the investment together, we can make the decision if the investment is profitable or not.

       T       K(t) – H(t)

Net present value of investment in education =  ∑      -------------- - (C(0) +F(0)

                                                                             T=1      (1+r)^t

When this sum is positive, the investment is a good investment. When the sum is negative, the investment should not be made.

On the short term, the returns on education will exceed the costs:

• When an person does know very little, there is much to be learned. A few years of schooling will already affect the productivity enormous.

• The costs of education are very low during the first year.

• C(0) is very low because of subsidies to education in the first years

• F(0) is very low because opportunity costs are very low if you’re young.

On the longer term, the cost of education could exceed the (financial) returns:

• At a certain point, extra education does not increase your wage anymore.

So, it is beneficial to invest in some amount of education, but there is an optimal point to stop. But even if the costs exceeds the financial returns, people can decide to make the investment, if the nonfinancial benefits of the education are very high.

Effect of changes in costs and benefits

Costs (C(0) + F(0)):

• Higher costs of education reduces enrollment. Individuals who where close to the margin where costs exceeds the benefits will now reach this point and decided not to invest.

• If the labor market is weak, opportunity costs will be lower and investments in education will rise.

Interest rate (r):

• Interest rate do not have a huge effect on the decision whether or not to invest in education. This is because education is an investment with in general a long payout period. Where the interest rate can vary on the short term, over the long term the interest rate is quite stable.

Length of the career (T):

• The longer the length of the career, the higher the optimal investment in education. So young people are more likely to invest in education, because they expected to gain the benefits of the investment for a longer period.

Also men are likely to invest more in education than women do, because women spent less time in the labor market and a lot of women interrupt their career for a couple of years because of fertility.

Specialization:

• People often specialize their education because of comparative advantage and gains from trade. Benefits are higher is everyone is specialized and trade their output with those who are specialized in other areas.

Effect of earnings (K-H):

• K – H is the difference in earnings because of the education. This difference depends on how much the learned skills are valued by the labor market. If the difference between K – H increases, this means, the higher the optimal investment in education.

4: Turnover

Costs and benefits

All firms should have some degree of employee turnover, but the question is how much and of what kind.

Benefits of turnover:

• Sorting: sorting increases the quality of the workforce, by screening the job candidates per period of time. This is only the case if differences in ability are valuable.

• New employees have new insights and have knowledge about the latest technology and developments. Therefore, turnover should be higher in firm where the technology changes rapidly.

• Turnover brings in new ideas which is important for organizational change. New employees can break with old habits.

• Promotion in the hierarchical level is necessary to incentive good employees to stay with the company. To make positions free, people also should leave the organization.

But sometimes it can also be very costly to have high turnover rate: This is especially the case in firms with high investments in firm specific training.

Different tools can be used to reduce the turnover rate:

• Increase compensation. The bottom line is that a firm has to pay the market value for important employees or they will lose these employees.

• Tailoring the job to that of the employee’s taste.

• Offering new opportunities to important employees, as job enrichment, promotion or training.

• Treat the employees fairly and fulfill promises.

But it is not always possible to reduce turnover. Then it is important to make the turnover at least less costly.

• Make sure that key knowledge is not monopolized in one employee by letting employees work together on key tasks.

• Cross train the employees to increase flexibility

• Standardize the job to reduce the cost of turnover

• Have a knowledge management strategy

Bidding

What should a firm do when an employee receives an offer from another firm and threatens to leave the current firm?

Winner’s curve: outside companies are in general in a weaker position to judge about the quality of an employee. Workers who are easy to steal are often those who are not worth it to steal.

This is because the current firm can always raise the salary of the employee, to keep him in the firm. If the outsider bid higher than the current employer will pay, he is maybe bidding too much. Only if an employee is more valuable to the outside employer, it may be profitable for an outside firm to launch a bid.

There are several conditions for a profitable raid:

• Employees who just completed an education program. There is a chance that the new degree employee can be more productive in another job than their current job. Outside firms can than offer this better job.

• Employees who are working in rapidly changing sectors. Because the circumstances are changing all the time, there is a change that their expectations are not being met, and therefore value the firm lower than another firm.

• Employees who are working in sectors with rapid technological changes. Some firms changes more rapid than other, and therefore are employees probably more worth elsewhere.

Offer matching

 When is it profitable to match outside offers and when is it not?

If a firm is matching any outside offer, the employee will search for a better offer if the expected present value of the increased earnings exceeds the costs of searching.

                                                                                                                    T      K(t) – H(t)

The expected present value of searching = chance to find better offer *   ∑    --------------

                                                                                                                        t=1    (1+r)^t

If this present value is higher than the expected costs, the employee will search. Low levels of searching costs and long work lives increases the likelihood to search for a better job offer.

If the employee is searching, the firm can match the offer, which increase the salary of the employee. But the firm can also decide to not match the offer. A no offer matching policy has the following influence on employee’s behavior:

• If the employee will leave the firm: then there is no difference between whether or not the firm has an offer matching policy or not. This is because the returns to the employees for searching are the same in both situations.

• If the employee is not willing to leave the firm: with an offer matching policy, the employee only has to threaten to leave the firm.

The offer matching policy is an incentive for the employee to search for an offer that he has no intention to accept. With a no offer matching policy, the employee would not search for a better offer, and saves money for the company.

So, if it is difficult for an organization to distinguish between if an employee really wants to leave or not, it is better to have a no offer matching policy. This is especially the case in the following situations:

• If the compensation includes a non-pecuniary component: this makes packages more difficult to compare. This means that employees are not just in the job for the money, and are therefore maybe less willing to leave the company when another firm offers a higher salary.

• If the employees are less paid than they are worth to the firm: especially when the employee is less paid than worth, there is room for the current firm to increase the salary. If the employee knows this, he can threaten with leaving to increase his wage. While, if the employee earns the same amount as he is worth, the current employee cannot increase wage when he get a better offer. So, the employee do not have to threaten the firm with leaving when he is not willing to leave, because this will have no effect.

Layoff

Who should a firm lay off as a result of downsizing? By deciding who to lay off, it is important to look at the balance of pay against productivity. The ones with the highest pay for performance should be targeted for layoffs.

Another important factor is the degree of firm specific human capital. Looking at this factors, the firm is best of when laying off those employees who have recently started within the firm and those who are near retirement.

• Employees near retirement: pay is below productivity, but there is little remaining profit for the organization to earn because the employee is likely to leave the organization in a couple of years.

• Relatively new employee: the firm loses little because there is just invested a limited amount of money in the firm specific human capital yet.

On the other side, the firm earns the highest profits on those employees who have already completed their training and still have a long remaining career. These are the middle age employees, who they should keep in the organization.

Young people are easy to lay off; they are not legally protected and have yet invested less in firm specific human capital.

Older employees are more difficult to lay off and it could even be illegal. Older employees are protected by regulations and have already invested a lot in firm specific human capital and are now gaining there benefits of the investments. Therefore, it can be very bad for the reputation and the trust of a firm to lay off old employees.

Buyout

Because of the difficulties around layoffs, firms can choose to buyout the employees. Buyout means that the employee agrees to end the employment with the firm in exchange for a compensation. Especially the most productive employees are likely to accept the buyout offer, because they are most likely to find a job elsewhere. Because this is not what the firm wants, buyout should be offered carefully.

In deciding whether or not to accept a buyout offer, the employee will compare the amount of money he get if he takes the buyout with the amount of money he can earn if he stays in the firm. Only if the first is higher than the latter, the employee will accept the offer.

The profit of the firm if the employee is bought out is the difference between the value of the compensation and the productivity of the employee. If the value of the compensation is higher than the productivity, the firm would like the employee to leave. As long as the gains for the firm of losing the employee is higher than the losses of the employee from leaving, there is room to make a deal. So, a buyout is possible if the present value of the employee’s best alternative is higher than the employee’s productivity in the current firm. Thus, low output and attractive alternatives makes buyout more likely.

Window plan: workers are only given a limited amount of time to accept the buyout offer. This is for the following reason:

• The buyout offer depends on the difference between productivity and wage. The lower the productivity, the higher the buyout that the firm is willing to offer. If the employee already knows that the buyout is coming, he will reduce his productivity to increase the offer.

But a shorter period also reduces the chance that the employee will find a good outside offer.

A way to increase the acceptance rate for buyout offers is to threaten employees to lay them off if they do not accept the offer. With the chance of lay off and having nothing, employees are more likely to accept a lower buyout offer.

Because downsizing can be very emotional and has huge impact on employees (and therefore maybe also on their productivity), it should be implemented very quickly. Besides that, maybe more employees should be laid off, to reduce the risk that they should do it again soon.

Retirement bridge: a buyout construction which offers an employee that is close to retirement benefits that equals their years of service + the difference between their age and normal retirement. Employees closer to retirement are therefore getting a lower buyout offer than younger employees.

Besides layoff or buyout offers, firms sometimes offer job placement services. This is good for their public relations, but can also save in costs. Because it increase the alternatives of employees, this employee is likely to accept a lower buyout offer. But the firm should only offer this service if they can provide it cheaper than the worker can do it for himself.

5: Making a decision

The biggest organization

The economy is the biggest organization. There is a lot of debate about how this organization functions optimal. On the one hand, people believe in centralized economies, run by the government. On the other hand, people believe in decentralized economies with much less influence from the government.

Since the end of the 20^th century, it is clear that the more decentralized economies are more efficient. Market oriented economies create more growth, jobs and wealth. Besides that, they are more able to adapt than more centralized economies.

In a decentralized economy, individuals are acting in their own self-interest. It is a self-organizing system, without any central player who is directing the market.

Because market oriented economies without a central planner is more efficient that a centralized economy planned by the government, it could also work in this way in organizations. It sounds logical that in designing a firm, you would hire a very talented person who can act as a central planner. But the opposite is true.

Benefits of a market economy

1. Importance of information system

Markets are a form of collective intelligence, which cannot be replicated by one single individual. To run an organization, you need information from all different functions; information that is unsystematic, unpredictable, local, and information that requires experience. Because of this complex nature, it is going to be very difficult or even impossible to communicate all this knowledge to one individual, the central planner. That is why an central planner decision maker is less effective.

Therefore, there should be made use of decentralization. Decentralized economies are more efficient because they make use of knowledge that comes from all different individuals.

Besides that, price is another economical information system. Prices are a important piece of information that is needed to coordinate resource allocation.

2. Importance of incentive systems

Another important system is incentive system of decentralized markets. Someone who owns an organization has an incentive to run the organization as effective as possible to become more profitable. A market oriented economy makes sure that resources have to be in the hands of those people who have the skills or knowledge that are most valuable to handle the resources. Therefore if the individual with the organization is not good in handling the business, he can do three things:

• Invest in human capital

• Rent out the land

• Sell the land

In all these options, someone with more knowledge or skills will gain influence on the organization.

In the situation of a central planned economy on the other hand, there would not be a strong incentive to run the business effectively.

3. Innovation

A third benefit of an market oriented economy is that these economies are more creative and adaptive. This occurs from to principles:

• Incentives make owners more motivated to respond to circumstances very quickly and effective. Besides that, these incentives can be invest in new products that could be profitable.

• Decentralization allows an economy/organization to make use of the ideas and creativity of all the individuals that are involved. This improves the ability to respond quickly to local circumstances.

Benefits of central planning

In some cases markets do not operate perfectly efficient. One example is a monopoly, which has the benefit of economies of scale.

Economies of scale: when the average total costs (cost per unit of output) decline as the firm gets larger. These scale benefits are especially caused by fixed costs, that do not vary with the level of output. Fixed costs in large businesses are distributed among more units than in small business, and therefore the cost per unit is lower. 

In the case of economies of scale, large firms can produce cheaper than smaller firms (because cost per unit decrease) and therefore the smaller firms will be driven out of business. And this can lead to a monopoly position of a large firm. 

Firms are often regulated by the government,so as to reduce the firm’s ability to use the monopoly power inefficiently.

Causes for market inefficiency by central planning are:

• Public good problem: some goods will not provided by private organizations because they are not able to charge enough to cover their costs.

• Externalities: when a transaction between a buyer and seller creates positive or negative externalities (benefits or costs) from a third party. Because buyer and seller will not be charged for these (especially) negative externalities, government should interfere with taxes or other policies to reduce these negative externalities.

Markets vs. Organizations

Organizations should have the same important functions as a market:

• Markets use knowledge that is dispersed throughout the whole economy. A important piece of knowledge is prices; a way to easily communicate the knowledge.

• If communication knowledge is too costly/difficult, decision-making should be moved to the location where the knowledge is.

• The price system coordinates

• Markets provide incentives for efficiency and adaptability

In the case of organizations, a model or organizational design should be made that ensures that the organization is able to:

• Make use of central and local knowledge

• Coordinate decisions

• Provide strong incentives to make good decisions

• Innovate and adapt

A first important issue is centralized or decentralized decision making. In this chapter the focus is on how a single decision should be made:

• A completely centralized decision should be made by the CEO of the organization.

• A completely decentralized decisions should be made by a line worker of the organization

• Some decisions should be made at middle levels

Benefits of centralization

1. Economies of scale

Sometimes, it can be difficult to determine how much of the cost of using an asset should be generated to each unit in the organization. This is especially the case if assets are intangible. Too overcome this problem, some responsibilities of creating, allocating and maintaining of shared assets should be centralized.

2. Make use of central knowledge

In some cases, the most important knowledge for the organization lies in the top of the organization. If information from all different units of departments flows to the top of the organization, the people on the top would be better able to see patterns than people at a lower level will. These decisions that should be taken on the top are especially decisions about the strategy of the organization, whereby combined information of the entire firm is needed.

3. Improve coordination

Centralization also improves coordination. Therefore, in a organization where more coordination is needed, more decisions should be taken centralized.

Coordination could be important because outputs of different units need to be combined, units need to be synchronized etc.

Benefits of decentralization

1. Overcome difficult/expensive communication

Information can be placed on a line from cheap to communicate to very expensive to communicate.

• Information that is cheap to communicate is often general knowledge.

• Information that is costly to communicate is often specific knowledge.

Costly means as well the real costs to transmit, but also the extent in which the receiver understand the information (actually the difficulty to communicate).

Based on this, a general difference can be made:

• General knowledge: is in general not so costly to communicate and should therefore be centralized

• Specific knowledge: is in general more costly to communicate and should therefore be decentralized

Some characteristics of specific knowledge/costly to communicate knowledge:

• Information that loses its value and should be acted on quickly

• Complex information, because of many variables or high interdependence between different pieces of information

• Information that requires advanced technical skills to be understood

• Information that is unforeseeable and change constantly

• Information that is subjective and therefore difficult to describe

2. Save management time

Decentralization is sometimes necessary to protect management for too many decisions. Decentralizing less important decisions that can easily be taken on lower levels, gives the top management more time to focus on the most important decisions.

3. Develops management skills

To develop good managers for the future, they should be able to learn skills as analysis and decision making on the job. Decentralization gives room for lower level managers to make decisions which are less important (and therefore also do not damage too much if they make a mistake), which is a good way to train for decisions which they should take if they promote into higher positions.

4. Job enrichment

By giving more tasks and responsibilities to workers, the job become more interesting for the worker and he will therefore become more intrinsic motivated to perform the job good.

Authority

By designing jobs, it is important to determine the level of authority and responsibility associated with the job. Besides the functions, the level of authority and responsibility depends also heavily on the job holder. The difference depends besides differences in functions also on differences in ability.

Important is the extent to which the jobholder has specific knowledge, which is costly to communicate. Also important is the extent to which the work of the jobholder should be coordinated with work of others.

The multistage process of decision making:

The decision making process can be seen as a multistage process which consist of four different stages:

1. Initiatives: coming up with a set of options

2. Ratification: one of the options must be chosen

3. Implementation: possible ways in which the strategy can be pursued

4. Monitoring: important that the implementation conforms the chosen strategy.

Dividing the decision making process in different steps is important because these different steps can be given to different people.

In general, it is more likely to decentralize stage 1 (initiatives) and 3 (implementation), which is often seen as decision management. On the other hand, stage 2 (ratification) and 4 (monitoring), which are often seen as decision control, should be more centralized.

There are two reasons for this:

• This difference balance the need to use specific knowledge from lower levels against the need for coordination from the top

• Employees do not have perfect incentives, so their interests are not always aligned with the interests of the firm. Therefore, the firm must limit that employees take decisions that are not in best interest of the firm, by retaining the right to ratify and monitor the decisions that are made by the employees.

Empowerment of employees thus often means that decision management is given to the employees, but (at least some of the) decisions control rights remain at the higher authority level.

Authoritarian relations:

A firm has a lot of different options how it sets up their authoritarian relations:

• Flat organization: each individual has more authority

à focus on decision management

• Steep authoritarian pyramid: each level has ability to veto decisions that are made by lower levels

à focus on decision control

Making the choose between flat of steep authority structures depends on the costs that are related with accepting poor projects in relation with the costs of rejecting good ones.

Accepting poor projects are false positive errors and rejecting good projects are false negative errors.

There is a tradeoff between those two errors. If you decide to reject all projects, you will never have a false positive error but a lot of false negative errors. If you decide to adopt every project, the contrary will happen. By deciding how aggressive an organization should be by accepting/rejecting new projects, they should look to how costly it is to make a false negative and a false positive error. But the goal is to enhance information that allows for fewer errors of each type. So make good informed decisions. But also information is costly.

A more hierarchical structure reduces false positive errors and increase false negative errors. More flat structures reduce false negative errors and have more false positive errors.

There are two reasons for this:

• In a hierarchical structures, there are two approvals instead of one

• In a hierarchical structure, two people are required for an evaluation, which lead to fewer decisions that are made. Thus, fewer projects are approved.

A third option is a flat structure with second opinions. The second opinions structure is less stringent than a hierarchical structure, but more stringent that a single opinion flat structure.

The differences in structure causes differences in the ratio that false positive and false negative errors exist. Which structure an organization should choose depends on the payoffs associated with each outcome.

3 payoff regimes:

1. Small upside, large downside:

Doing the job right results in small gains, but making a mistake implies enormous losses.

à Firm will minimize false positive errors and more willing to accept false negative errors and should therefore adopt a hierarchical decision making process.

2. Large upside, small downside:

Doing the job right results in big gains, but making a mistake do not causes big losses. For example new firms, which has little reputation or capital to lose, and much to gain.

à Firm will minimize false negative errors and more willing to accept false positive errors and should therefore adopt a flatter structure.

3. Symmetric payoffs:

Both right performance and bad performance do not create disastrous losses of gains.

à Firm will prefer tolerable levels of false positive errors and false negative errors.

By different payoff regimes, the ratio between false positive errors and false negative errors should change.

But the overall goal is of course to reduce the total of errors; to make sure that as well less false positive errors as false negative errors exist as in a normal situation. To reach this goal, improvements in the decision process should be made:

• Get better evaluators by hire more able and therefore often also higher prices workers.

• Give evaluators more time to evaluate the project

• Make more information available for the evaluator, by for example buying extra data about the project

If each of these improvements is profitable, depends on how much is gained relatively to the amount that should be lost because of poor decision making.

Summary

Organizations are much more than just a sum of individual workers who are performing physical tasks. Organizations are more and more seen as a processor of knowledge. Therefore, the structure of organizations has the goal to make the use of information more efficient, adaptable and innovative.

Economies face the same issues as organizations do. The most effective way to organize an economy is a market-oriented structure. Market oriented economies provides decentralization to ensure that specific knowledge can be exploited.

A market economy is a self-organizing system, with little central direction. However, there is a great amount of coordination because of prices, which is useful information and guide the decisions of decision makers.

Besides that, markets work efficiently because of strong incentives. Because individuals can own assets and they are responsible for their own profitability, there is a strong incentive to make the right decisions, in order to maximize their value.

The market is a kind of metaphor for what happens in organizations. An organization is actually a small economy on its own. Therefore, also the goals of organizations are the following:

• Use information throughout the organization

• Coordinate across the organization

• Provide incentives to maximize value

6: The structure of organizations

In the previous chapter, the focus was on the allocation of individual decisions. In this chapter the focus is on a more macro level: the structure of the entire organization.

Different organizational structures

There are several general types of organizational structures that firms use. In reality, organizations often make use of a combination of these structures. 

Every organizational structure makes use of hierarchy.

Hierarchy means that most communication, supervision and decision making occurs in a clear paths from the bottom to the top of the organization. Hereby, the ultimate authority lies with the CEO of the organization.

Almost all structures make use of hierarchy in decision making. In this way it is clear who the ultimate decision maker is, what will make the process quicker.

There are four general types of organizational structure that will be discussed:

1. Functional structure:

 The most important element is the use of functional organizational units.

If a firm grows to a substantial size, the structure should be broken up in smaller and better manageable subunits. A common way is to group employees who are similar in a certain way  (for example because they have related skills or tasks) together. In an organization, there would be different units for example R&D, sales, production and finance.

In such an organizational structure, someone’s career will be solely within the function.

A functional structure brings forward several benefits:

• An important benefit of functional structures is specialization. To perform a job, a functional employee should just have knowledge and skills related to his functional area.

• Together with the specialization, a functional structure makes it possible to design narrow jobs with a limited amount of tasks. And narrow jobs is quite compatible with narrowly focused human capital.

• A functional structure has often a smooth hierarchy. Because employees work their whole career in the same functional area and promoted upward, a boss usually supervises jobs that are very much like the jobs he had worked in before his promotion. Therefore, it is likely that he will be a more effective manager; communication will be easier and performance evaluation more accurate.

Besides these benefits, there are also several disadvantages of a functional organizational structure:

• Specialization brings forward, that workers have less understanding of how their work affects the work of other employees in the organization. Therefore, their work will be badly coordinated with that of other functions.

2. Divisional structure

The larger a firm grows, the more the need to break the structure into smaller and better manageable subunits. If these firms are complex, with multiple product lines, regions and a greater variety of techniques and technologies, is could be difficult to coordinate units across functions.

Therefore, most large firms break their structure into divisions. In a divisional structure, each division is focused on a narrow part of the overall company business. Each division would be assigned to a particular area of focus. This simplifies the mission and operation of each division. Within each division, the firm could make use of a functional hierarchy.

By dividing the organization into divisions, several divisional structures could be used. In these different structures, the firm is organized into for example:

• Product divisions

• Customer types

• Technological lines

• Regional divisions

Organizing an organization into subdivisions means that the organization becomes a set of autonomous minifirms. Specialization of incentives, strategy, skills and job design within each subdivision may mean that the several divisions do not consider the effects of their work on the other divisions.

Coordination problems could occur because the different organizational divisions could have positive or negative externalities on each other.

Positive externalities mean that there is inadequate cooperation.

Negative externalities mean that there is too much competition.

Therefore is it the job of the top management to oversee the activities of all the divisions and to improve the coordination between them.

A firm can organize different parts of the organization into different structures. General functions could be centralized for the entire organization (for example R&D to maximize value because of economies of scale). Other departments could then be organized into customer divisions (for example marketing, to maximize flexibility in selling techniques). And again others could be organized into region (for example production to reduce distribution costs).

A divisional structure has besides its advantages also some disadvantages:

• The more the firm is organized by different lines, the more complex the organization become to manage.

• Firm loses some of the gains from specialization

• Firm loses some of the gains from economies of scale

3. Matrix structure

The matrix structure provides a balance for economies of scale in specialized functional structures against the desire for a divisional structure. In the matrix structure, the organization is organized into as well functional as divisional areas. Each employee is assigned to two groups: the functional and the divisional. Therefore, each employee also has two bosses.

The matrix structure has a lot of the benefits of both the functional and the divisional structures.

• Focus investments in human capital

• Clear career path

• Improved coordination

But the matrix structure also has some disadvantages:

• Conflicting goals because of two bosses

• Slower decision making

• More bureaucracy

The matrix structure is a very complex and costly structure and should therefore only be used if the advantages of such a structure are high enough.

4. Network structure

The network structure came up in the last two decades. It is a structure that focuses more on informal relationships between individual workers and managers as well inside as outside the organization. Instead of the formal chain of decision-making, an employee can directly contact a colleague, which make the decision making process more quickly.

The idea behind the network structure is that not all work has to be organized into traditional hierarchies.

A disadvantage of the network structure is that it can undermine the formal chain of command.

Choose a structure

An organization should not use one single structure for their entire organization. They should make use of mixes of structures for different parts in their organization.

By choosing a structure for an area in the organization, it is always important to consider two important principles:

1. Principle of a single decision maker

2. Value of specialization

Therefore, almost every firm makes use of functional structures. Even in network structures, it is important to clearly specify leaders and goals of all organizational units.

But besides specialization and authority, also other factors are important.

3. Complexity:

   • complexity implies that there is more specific knowledge at lower levels in the organization. Therefore, greater complexity asks for more decentralization of the organization.

   • Complexity implies that there are more areas that the firm has to consider. Therefore, the organization should be differentiating into smaller organizational units. This put pressure for divisions and subdivisions instead of just a functional organization.

   • The more complex the business, the more complex the structure à divisional, matrix of a network structure.

4. Stability of the environment:

   • The more stable the environment, the less important specific knowledge from lower levels are. Therefore, in stable organizations, decisions should be made centralized. In a more changing environment, specific knowledge from lower levels become more important and decisions should be made more decentralized.

   • Stability implies that the firm has mastered its business processes, and formal procedures can be established.

5. Coordination

The coordination factor will be discussed in the section beneath.

Coordination

Another important factor (factor 5) in choosing the optimal structure for an organization (area) is the nature of the coordination problem.

Coordination is needed when work from different units in the organization have to be combined to create greater value for the firm.

There are two general types of coordination problems.

• Synchronization problem: a coordination problem that does not require units to communicate with each other in order to coordinate. For example the quantity and timing of assembly line work.

à synchronization problems can be coordination through several mechanisms:

• central budgeting and planning

• training and standard operating procedures

• corporate culture

• communication

• general managers, laisons and job rotation

• personality

• networks

• performance evaluation and incentives

• Integration problem: Multiple pieces of specific knowledge that must be combined to make a decision.

à The best way to overcome an integration problem is to make sure that the one with pieces of specific knowledge that are needed to make a decision do work together. And this is exactly what a matrix structure is designed for.

Implementation of a organizational structure

Almost all firms make use of a hierarchy in some extent.

Firms face a tradeoff in their choice how to structure a hierarchy. This tradeoff is between span of control versus the number of levels.

Hierarchical structure:

• increased costs

• less innovation

• information processing and decision making slower

Flatter structure:

• higher span of control (number of employees that are reporting to one single manager)

• reduce costs because of less layers

• increased costs because managers must supervise more subordinates

• reduced effectiveness of supervision

There are many factors that affect the optimal span of control and the numbers of levels in the hierarchy.

• Type of tasks to be performed: route work which is easier to manage implies a larger span of control and a smaller number of hierarchical levels.

• Skills of managers and subordinates: higher skills increase the optimal span of control and reduce the number of hierarchical levels.

• Incentive problems: if there are good incentive plans, the span of control can be greater and the number of hierarchical levels reduced.

• Cost of acquiring and communicating knowledge: lower costs of acquiring and communicating knowledge increases productivity of workers and therefore span of control can increase. The mangers will be able to analyze inputs from more employees. Therefore, information technology affects the number of hierarchical levels in the organization.

Hierarchical level, productivity and compensation

Each manager makes his subordinates more effective in their work, and this in turn also increases the productivity of their subordinates, which are already two levels lower than the manager. Therefore, the productivity of an manager affects the productivity of all the employees below him.

For this reason, the effect of ability rises with hierarchical level. This has some consequences:

• The best employees should be in the top of the organization. Therefore there should be made use of internal labor market (where the best employees in the organization make upward promotion).

• Compensation should rise with the hierarchical level of the employee.

Organizational structure evaluation

The best structure for an organization evolves during the life cycle of the organization.

In the starting up period of a new firm, the organizational structure should be flatter, because of several reasons:

• The damages of mistakes are very low while their potential gains from successes are very high.

• Focus should be on innovation and taking risk

• Young firms often are smaller firms

As a firm grows, it is likely to adopt a more formal structure and hierarchy, because of the following reasons:

• Larger number of employees make an informal structure less efficient

• Because the firm now has a more established brand and products, it should be more conservative in decision making

• It is possible to standardize procedures, because the organization has had time to learn good methods.

• The fact that the organization still exists means that the environment is relatively stable.

An fascinating phenomenon is churning of the organization structure. With this phenomenon, firms change some elements of their structure quite often. A good explanation for this is that no organizational structure is perfect.

7: Designs of jobs

Job design characteristics

Four important characteristics of jobs are as following:

• Multitasking: measures the extent to which the job requires the employee to perform more than one task

• Discretion: the value of discretion refers to the extent to which the job requires an employee to make decisions

• Skills: measures the ability and human capital in as well breadth as depth of an employee, required to perform the job

• Interdependence: measures how close the job is related to other jobs in the same organization

Important is to look if these job characteristics are related to each other or not. You do that in this way:

1. Calculate the probability that you observe two characteristics at the same time. This predicted probability = probability characteristic 1 * probability characteristic 2

2. Compare the predicted probability with the actual occurrence of characteristic 1 and 2 at the same time

3. If the actual occurrence is very different from the predicted probability, there is a statistical relationship between these two characteristics.

If you make this calculation for the four job characteristics as mentioned above, you will see that there is a correlation between those characteristics. Therefore, firms should use coherent job designs. The jobs should score low, medium or high on all four characteristics.

Other important conclusions about the relationship between the characteristics:

• Two very important characteristics of job design are the extent to which an employee should make decisions and the amount of tasks an employee performs

• There is a clear path in the design of jobs

• Multitasking is related to discretion, and both are related with more highly skilled employees.

• A job that scores low on all these dimensions is called a narrow job

• A job that scores high on all these dimensions is called an enriched job

• There is a relation between the interdependence of jobs and the extent in which a job should be enriched or narrowed.

• Interdependent jobs should be more enriched

• Less independent jobs should be designed to be narrower

• Over the last decades, there has been a trend away from narrow job toward more enriched jobs.

Optimal job design: which tasks to put together in a job

Multiskilling

Multitasking: the extent to which the job requires the employee to perform a number of different tasks.

Multiskilling: the extent to which the employee has the ability to perform a number of different tasks.

A lot of benefits that are often ascribed to multitasking are actually advantages of multiskilling; that the tasks are not associated with the job, but that the employee has the ability to perform those tasks when it is needed.

Advantages of multiskilling are:

• Flexibility: workers with the ability to perform a large number of tasks are able to fill in for other workers. Flexibility is especially important in small companies, where there is often just one person who performs a certain job. Without flexibility, a small company cannot work if one worker is sick.

• Communication: multiskilled people are more likely to communicate with individuals in different jobs in the firm. This is because it is much easier to talk about areas, which you are familiar with.

• Innovation: Multiskilling improves innovation on the job in two ways:

• An individual who knows many aspects should easier design process improving technology

• If individuals are highly specialized, a given innovation is more likely to cause all of their human capital to become obsolete.  And these workers who see their skills become obsolete will therefore resist to innovation.

Tasks

Specialization is the opposite of multitasking.

The degree of specialization is limited by the extent of the market. If the market requires producing just a very low amount of a certain product, it is impractical to have narrow jobs where people are specialized in a certain task. Therefore, smaller firms are more likely to make use of multitasking in their job design, which make multiskilling also more important.

In a larger firm however, breaking the work into narrow tasks (specialization) can result in an increase in productivity.

Reasons for this increased productivity:

• Employees who just have to focus on one or a limited amount of tasks have more chance to perfect those tasks.

• Employees who just have to focus on one or a limited amount of tasks save time associated with switching between tasks

• Employees who just have to focus on one or a limited amount of tasks just need specialized human capital, which reduce training costs

• When putting different tasks together, an employee could get focused on one tasks and thereby ignore the other task.

This is especially the case if the worker prefers one task over another or the outcomes of one task are more visible than the outcomes of the other. In this case, it is more preferable to split up the tasks

As said, multitasking is the opposite of specialization. Benefits for multitasking are the following:

• Lower transaction costs: different costs can be reduced because of multitasking:

• Transportation time: with specialization, the work on progress have to shift from one employee to another for the next tasks. With making use of multitasking, such costs can be reduced.

• Setup time: when more employees work on the same product, all these people have to learn some of the details of that product. With making use of multitasking, some setup costs can be reduced.

• Bureaucracy costs: when more employees work on the same product, the product should be passed on from desk to desk. This shifting moment creates a tendency for an employee to put the product of for some time.

• Some skills of an employee associated with one task allow the employee to also perform a related task. When this is the case, multitasking is very cheap. But when this is not the case, it can be very costly. Therefore, when putting different tasks together in a job, it is important to ensure that the job holder has the needed tasks to perform all of these tasks.

• Complementarities: a huge benefit of multitasking occurs when performing one tasks makes the employee more efficient in also performing another task. This is the case with product which are complementary in production and this occurs especially when tasks are interrelated in the production process.

• Learning: a multitasking employee is more likely to improve the process or product he is working on. The most difficult parts to improve are the ones which are complex and interrelated. And these processes are the ones where multitasking employees work on. A worker who produces different parts is more likely to consider and improve how both tasks will function together.

• Multitasking increases the intrinsic motivation of an employee.

Decision making

Because multitasking increases the amount of on-the-job learning, employees who multitask often have also more rights to make decisions.

• Employees with multitasking jobs often have specific knowledge because it is complex. Because this specific knowledge is costly to communicate, the employee should get the responsibility to make his own decisions; to try out new things.

Optimal job design

The information above makes clear why the different job characteristics are positively interrelated.

• Multitasking is related with interdependence, because in interdependent processes is more to learn.

• Employees with a multitasking job should have more discretion, to give them the change to try out new thing and exploit their ideas and knowledge.

• Multitasking is related to skills, because employees who multitask need more skills to perform these different tasks.

However all these characteristics are interrelated, it does not mean that all jobs should be enriched with high level of multitasking, skills, interdependence and discretion. If a narrow or a enriched job is better depends on the circumstances.

But in every situation it is important to synchronize the human resource policy with the job design. It makes no sense to decentralize decision making if all employees have narrow jobs with low skills.

Types of job design in different situations

A lot of companies still make use of very classical approaches, while there are already much more modern types of job design. There are several reasons for this:

• It is costly to change policy

• Managers sometimes do not know which policies are the best of most suitable in their situation

• Modern types of job design are not always the best option

Especially the last explanation is an interesting one. In some organizations the modern types of job design with job enrichment are very effective, but in other organization a more traditional design fits better.

Taylorism

Taylorism is a scientific management movement of the early 20^th century.  The behind Taylorism is that talented engineers in the organization look for the best possible way to organize the production produce and the best way to perform each specific task. They break the process into individual tasks and perfect all these tasks. In this way, the efficiency of the production process can increase.

Because the engineers just have to perform the tasks as the engineers has designed them, workers should have less discretion. Besides that, because the tasks are already optimized and specialized, the employees do not have to focus on job learning.

The idea of Taylorism works especially in routine work situations (for example an assembly line), where all workers just have to perform a small number of tasks repetitively.

So Taylorism can be lead to very efficient and effective processes while making use of centralization, narrow job design and low skilled workers.

Continuous improvement

In other situations, organizations increase their effectiveness and efficiency through continuous improvements through more modern methods as multitasking, decentralization and high skilled workers.

But most organizations organize their organization with a structure somewhere between Taylorism and continuous improvement. Or make use of different methods in different parts of the organization. So an organization do not have to adopt one of the approaches, but have to look which approach works best for which workers.

The question is in which situation Taylorism works well and in which situation continuous improvements works better:

• Size of the firm: the larger the firm is, the more beneficial Taylorism will be. Larger firms have more workers performing similar tasks.

• Complexity: simple processes are more easy to optimize upfront, and therefore Taylorism will be useful. In more complex situations, Taylorism will be too costly and difficult and there is more opportunity for worker to make on the job improvements.  Complexity is visible in several ways:

• Number of steps in the process

• Number of product in the product line

• Amount of interdependence between tasks

• Predictability: Taylorism will work is they know what situation the employees will face. On the other hand, more unpredictable environments will lead to more continuous improvement methods.

• Time: If an organization is already in business for many years, it will already have figured out how to perform tasks as effective as possible. When this is the case, it can adopt more formal procedures and policies and make use of centralized decision making. While in the starting up years of a company, it should make use of continuous improvements to figure out under way what is most effective.

Firms undergoing organizational change are more likely to use continuous improvement methods. This is because change implies that the previous methods no longer apply and employees have to think about ways to improve the processes.

Because change occurs more and more recently because of globalization, fast improvements in technology and deregulation, there has been a trend toward continuous improvements. That is why highly skilled workers will become more valued than before.

Motivation

An important topic in job design is how to design jobs to increase the intrinsic motivation of employees. According to Richard Hackman, five job design characteristics can increase an employee’s motivation:

• Skill variety: people with the ability to perform more tasks are more motivated. This effect is strongest when the worker has the opportunity to learn on the job.

• Task identity: the extent to which a employee’s job is observable

• Task significance: the extent to which the employee find the work he is doing personally valuable.

• Autonomy: gives the employee more discretion how the work is performed and more ability to make decisions.

• Feedback: give employee information on the effects of actions and decisions. This is necessary to diagnose problems, test new ideas and implement the good ones.

Overall, intrinsic motivation increases when the employee is intellectually challenged by the job.

8: Developed job design

Teamwork

There are two reasons why you should be careful with using teamwork:

• Decision making: with group decision making, workers often get into too much discussion and politics. This is especially when there is not a clear, single leader.

• Free rider effect: within team, group members can easily hide themselves behind the productivity of other team members. If team members are compensated on the basis of team output, they will be less motivated to do the best they can.

Because of these benefits, teams should only be used when there is a good reason to do so.

Benefits of teamwork:

• Multitasking: when tasks are highly complementary, it will be beneficial to put these tasks together. When these tasks are too big for one worker, they should be given to a team of workers.

• Teams can provide coordination between different workers but also between different organizational units.

• Specialization: in a team, each individual can specialize on a set of all the necessary tasks that should be performed. In most teams workers do not perform all tasks. They specialize and often rotate jobs from time to time. Through job rotation, they have many of the benefits of intertask learning, while they also avoid the benefits from specialization.

• Transfer of knowledge: 

• for knowledge transfer to be valuable,  individuals should have knowledge that is also relevant for the others. 

• If there is too much overlap in knowledge, there will not be so much knowledge transfer.

These two factors should be considered when choosing members for a team.

Team implementation

There are some factors to think about when implementing teams:

• Job rotation: to balance the benefits of intertask learning against the benefits of specialization

• Team size: it is important to think about the size of the team

• Too small teams do not have the benefits of valuable knowledge transfer

• Large teams have communication problems

• Peer monitoring: peer monitoring can reduce the effect of free rider. Peer pressure is often in the form of norms. Another way is to set quotas or rewards. When the group does not reach the quota or the goal for which they get a bonus because of less effort from one person, this person will feel the pressure from the other to perform better.

Peer monitoring is especially effective in small teams.

• In a small group it is much easier to know what other workers are doing.

• In large teams, one member’s shrinking does not affect the interest of another member heavily

• It is more difficult to observe shirkers in large teams.

Team composition

There are different ways that can be used for team member selection:

• Alternating draws: allow the head of each team to choose a new member in alternating order.  But this method for team member selection does often not result in the most efficient allocation of team members.

• Bidding for members: another method is to allow teams to bid for new team members. The team with the highest bid gets the member. With this method, teams are likely to bid higher if the new team member is likely that he will have a high value for the team. Therefore, bidding for team members will often lead to a efficient allocation of team members.

Information technology

In the last decades there has have been enormous improvements in the capabilities and speed of information technology. These developments have their effect on as well organizational and job design.

Effect of IT on organizational design

• Communication costs reduced enormous. Therefore, a lot of knowledge that was specific knowledge before the IT revolution, now turned into general knowledge. Therefore, IT leads in many examples to greater centralization of decision making. In this situation, employees will have less discretion and more narrow jobs designs, and need therefore lower skills and receive less training.

• On the other side, IT also can lead to decentralization. With the use of IT, information can be easily and cheaper provided to lower level employees to support their own decision making.  Employees are better able to collect and analyze data on their own.

• IT leads to higher productivity. If the same amount of employees can produce more output, this may lead to smaller firms if you look at the number of employees. But it could also lead to larger firms if you look at the output. 

• IT makes customization cheaper, and thereby encourage firms to adopt a more flexible organizational structure.

• IT speeds up communication, and thereby decision making.

Effect of IT on job design

As mentioned above, IT can lead to narrow jobs with little discretion and skills but also at more enriched jobs. What happens with the job design depends heavily on the issue if computers are used as substitutes for people or as a complement.

• Computers as substitute for people: computers will use computers instead of people if they have lower costs, higher productivity, or both. In other words, if they are better at performing a job than people are.

Computers have several advantages over people:

• They are reliable: come always, never to late etc.

• They do not have motivation problems

• They are predictable

This implies that computers will perform as well as people or even better in certain situations.

• Applying rule-based logic

• If there are fewer interdependencies between tasks

• If the work is predictable

People cannot be substituted by computers: in several situations it become very difficult or impossible to make use of computers instead of people.

• People are much better at pattern recognition than computers are

  • Abstraction: the ability of people to developing a general principle from specific circumstances and applying this principle to new situations.

  • Creative work is impossible to do with computers.

So, jobs in which computers can easily substitute for people are those with:

• Routinized tasks

• Low discretion

• Low use of multitasking

• Low skills

• Computers as complementary tool: In other jobs, computers cannot substitute for people. But also in these jobs, there can be made use of computers.

• Computers can be used as a decision support tool for people.

To conclude, IT can substitute for people in classical jobs with low scores on skills, discretion, multitasking and interdependency. On the other hand, IT can be used as a complementary tool in for example decision making in enriched jobs with high scores on skills, discretion, multitasking and interdependency.

Computers destroyed jobs of the first type and it created jobs of the second type. That is why the IT revolution has not led to an increase in the overall unemployment.

HROs

Highly reliability organizations (HROs) are organizations in which the costs of mistakes are very high. An example is an emergency room in a hospital. In HROs it is important that they act quickly in often unpredictable situations. Therefore decentralization is very important.

Common principles of HROs are:

• Having two parallel structures: one for normal activities and one for high pressure periods with high risks. During the quiet periods, the organization is getting prepared for the high risk periods. Quiet periods are associated with slower decision making (also more centralized), training and preparation.

      High risk periods are associated with immediate action through decentralized  

      decision making.

• Use as much classical methods as possible. Predict as much as possible, laying down rules and procedures to follow when events occur.

• Training: because the circumstances are often unpredictable, people are trained in abstract principles to guide them in how to react to these unknown situations.

• Redundant systems, make use of backup systems, extra inventory or cross training.

9: Evaluating employee’s performance

Introduction in paying for performance

Besides intrinsic motivation, firms try to trigger also the extrinsic motivation of their employees by making use of pay for performance.

There are several reasons for making use of pay for performance:

• Employees do strongly respond to incentives. Therefore, good incentives systems can create value for the organization.

• Even if the employee has already a very high internal motivation, this motivation can be not aligned with the organizational objectives. By making use of pay for performance, the firm can easily link employees effort to the organizational objectives.

• The extent to which the behavior of employees is caused by the environment, including rewards, is underestimated. But it is just this part that the firm can easily alter.

• Pay for performance improves many human resource objectives. For example self selection in recruiting.

The basis for most incentive problems is the principal-agent problem. This problem is visible when the agent (employee) acts on behalf of the principle (owner of the firm), but has other objectives than the principle has.  There is a conflict of interest if the employee has too little motivation to provide various kinds of effort. For example if an employee works to slow. If the firm formalize actions to ensure that the employee is going to work harder, this is costly for the employee, because he prefers to work slower. These costs are psychological costs and called disutility of effort.  Another cost for employees is risk. The risk that there pay for performance is partly based on some factors that are beyond the control of the employee.

In an ideal situation the employee’s pay is totally based on the performance measure. But the net value that the employee perceives from working for the firm is different. This is:

Pay (based on performance measure) – disutility of effort (C)– the cost of the riskiness of pay

And therefore, the firm must also compensate the employee for disutility costs and risk costs.

Performance evaluation

Evaluation depends on ability, accumulated human capital and efforts.

Performance evaluation is the most difficult part of any incentive scheme. This is because of the following difficulties:

• Employees work in groups which make it difficult to see who is responsible to what

• You cannot observe anything the employees do

• Employee’s performance  can be partly a result of luck

• Contributions can be very hard to quantify even if they are clearly observed

Besides the difficulty of good performance evaluation, it can also be very costly and time consuming. But despite this, performance evaluation is very important and therefore should be done very carefully.

There are different ways to evaluate employee’s performance:

• Output based performance measures:

• Broad measure: estimate the employee’s overall contribution to the firm value. The stock price is important in this method

• Narrow measure: estimate difference dimensions of performance. For example the quantity of output

• Combined method: combine several estimations of different dimensions of performance. For example costs, output, quality

• Input based performance measures, such as amount of hours worked or number of tasks.

Besides the distinction between output and input based performance measures, there is also a difference between quantitative or qualitative performance measures.

Quantitative performance measures

Quantitative performance measures have the following advantages:

• Because quantitative performance measures are numeric, they can be easily be tied to compensation by using a formula.

• Quantitative performance measures are seen as more objective in their evaluation.

A manager should look at five different properties in determining a good measure for incentives:

1. Risk profile

2. Distortion

3. Scope

4. Matching to job design

5. Potential for manipulation

1. Risk profile

All performance measures have some risk in it.

These risks can be distinguished in two important types of risks:

• Uncontrollable risk: variation in performance for which the individual has not the ability to control it. Because an individual cannot control this variation, but it does influence the performance measure, it is an risk for the individual.

A firm can do several things to respond to this uncontrollable risk:

• It could choose for a less risky measure

• It could weaken the link between pay and performance to reduce the risk

• It could raise salary to compensate for the risk

• Controllable risk: variation in the performance for which the employee has some ability to control it.

In the case of controllable risk, the organization should do the opposite with the incentive plans as with uncontrollable risk. The firm should increase the link between payment and risk to motivate the people to use their skills/knowledge/experience or whatever to control this risk.

2. Distortion

An ideal performance measure it totally based on the employee’s impact on the firm value, and nothing more.

A firm can choose between broad performance measures of more narrow performance measures.

• Broad performance measures: broad performance measures includes more factors of performance. An example of a broad performance measure is the stock price.

• Low distortion: broad performance measures distort incentives less because they focus on more dimensions of the employee’s performance in the evaluation.

• High risk: by looking at more dimensions of employee’s performance, also more uncontrollable are included. This causes higher risk.

• Narrow performance measures: narrow performance measures includes fewer factors of performance. An example of narrow performance measure is the amount of output. Narrower performance measures may be chosen because they are easier to measure than broad measures are.

• High distortion: narrow performance measures distort incentives. Just measuring one factor will lead to that the employee will just focus on that objective. In case of the example, the employee will make as much products as possible, without thinking about the quality.

• Low risk: narrow performance measure focused more on things that the employee can control and is therefore less risky.

3. Scope

There are several causes of distorted performance measures:

• Intangibles: intangibles are difficult to quantify. An example is customer satisfaction.

• Opportunity costs: opportunity costs are costs of foregoing other alternatives. Standard accounting number do not include these opportunity costs.

• Group size: employees are interdependent in production, and therefore measures of individual performance will distort incentives. But on the other hand, broad measure with group or business performance will measure more uncontrollable factors, and is therefore more risky.

• Time horizon: most of the performance measures look back in the time. They measure what is already happened. But they distort incentives for actions with long term effects.

4. Matching to job design

It is important to match the performance measure to the job design. The scope of the performance measure should for example be matched with the extent to which the employee’s job is narrow or broad. Other things equal, the more tasks that an employee has, the broader the performance measure should be.

This is to ensure that the task for which the employee is responsible are all reflected in the evaluation measures.

But this matching principle will happen automatically. Because if an employee with very little discretion is evaluated on a broad performance measure, he will face a lot of risk. To reduce this risk, he will ask (or just taking on) for more responsibilities, to increase his control over factors for which he will be evaluated.

5. Manipulation

Another problem with quantitative performance measures is that they may be manipulated. In the case of worked hours as only performance measure, an employee maybe will lie about his working hours. This improves his performance measure, but not the organizational value.

As with distortion, manipulation is more likely to occur when there is made use of narrower performance measure. The employee then just have to manipulate one aspect of his performance.

Qualitative performance measure

Most managers do not like to give subjective performance evaluations. Managers are reluctant to give low rating to their employees, this is the leniency bias.

Employees do not like subjective evaluations too. They are worried about the fact that the evaluation reflects the supervisor’s personal opinions and biases.

But subjective performance measure plays an important role in evaluating different jobs. Especially for jobs where quantitative performance measure does not exist.

It is important to think about how to evaluate employees:

• Retrospectively: when evaluating retrospectively, you look back on what the employees did over the last period of time. When you make use of this looking back evaluation it is important that you avoid hindsight bias.

Hindsight bias: the evaluator is likely to know more after a certain events has happened than the employee knew when the event occurred. It is important to figure out if the employee did knew these things at that time. Hereby it is important to analyze the extent to which a certain event was foreseeable.

• Prospectively: when evaluating prospectively you discuss with the employee what is happened, what he did and why he did it in that way, and what he should have done instead. In this way, precedents are set about what will be rewarded in the future. 

In a good evaluation, the managers should clarify to the employee what he expect to focus on and for what he is responsible. Mistakes  should be discussed, and should be a lesson for the future.

Subjective evaluation has the following benefits:

• Subjective evaluation can be used to improve quantitative performance measures.

• Subjective evaluation can filter out the uncontrollable factors and thereby lowering the risk.

• subjective evaluation could reduce distortion in incentives. When these factors are hard to quantify, they still can be included in the evaluation, and thereby motivate these tasks.

• Subjective evaluation can reduce manipulation of incentive systems.

• Improves incentives for risk taking: subjective evaluation gives evaluators more flexibility to reward good results without punishing for mistakes.

• Makes the incentive system more flexible: incentive plans that worked earlier quite well could be no longer ideal if the circumstances change. When this happens, the firm has to change the incentive system. But this could be perceived as unfair by the employees. But this change is more likely to be accepted by employees in subjective performance measure, because the evaluation already depends on the judgment of the evaluator.

• Increase communication: the evaluator monitors what the employees does, discussed why and suggests improvements. For subjective evaluation to become effective, clear communication is needed.

• Improves training: regular subjective evaluation with discussion between manager and employee can be a form of day-to-day training.

Important in subjective evaluation is to consider who is going to evaluate whom. Evaluations are often decentralized. The reason for this is that evaluations makes use of subjective knowledge that is very costly to communicate. Therefore, the evaluation should be decentralized to the direct supervisor of the employee.

Other firms make use of 360 degree evaluations, which involves the subordinates in evaluating the supervisor. An advantage is that it can improve management, but a downside is that subordinates are afraid for retribution if they have critic on their supervisor. Therefore, 360 degree evaluation should be done anonymously.  360 degree evaluation is especially effective in organizations with an open culture and open communication.

Disadvantages of subjective performance measure are the following:

• Subjective performance measure makes it easier for evaluators to discriminate and be biased in allocating rewards. Because in this case, other factors than performance affect the rewards, it increases the risk. In general, the higher the trust that the employee has for the manager, the more effective subjective performance measure is as part of the incentive system. Also the reputation of the manager is important. Besides that, formal policies should be used to increase the fairness of the evaluation system. An example is the option for employees to ask for re-evaluation.

• Influence costs. Subjective performance measure may also distort employee incentives if employees are trying to influence their supervisor. If these lobbying activities are done instead of productive effort, this impose influence costs on the organization. Besides that, it may influence the decision making.

As mentioned before, employee performance depends on ability, human capital and efforts. So evaluation can be used to measure any of these three factors. But in practice, it can be very difficult to sort out which factor causes specific performance.

But it can be beneficial to distinguish this. For example in selection, performance evaluation should be especially focus on the person’s ability. Skills and effort can also be trained later.

The frequency of evaluation should decline with the time an employee is working in the company. The longer he works for the company, the better both the employee and mangers know if the employee is a good match for the job.

10: Rewards

After discussing how the performance evaluation should look like, it is important to know how the firm can make use of the evaluation.

• Performance evaluation could be used to motivate employees.

• Pay to performance improves the firm’s ability to recruit better employees. Because those who believe that they will be very productive for the firm are more likely to apply for the job than those who think they are not.

• Pay to performance increases employees effort

• Pay to performance align employees effort with the interests of the firm

Incentives are of enormous importance for an effective organization and even for effective economies. But how should this pay for performance system look like?

Lets first consider a very common form of pay for performance:

Pay= A+ B * PM

A= base salary

B= commission rate

PM= performance measure

The higher the base salary, the more the worker will be motivated, but only to the extent that he will avoid to get fired. This is in general a very weak incentive.

More important about the incentive is how the pay varies with performance. The slope of the pay for performance relationship is called the incentive intensity. But what should this intensity be?

So, when designing a compensation plan for employees, you should consider three steps:

1. What performance evaluation make you use of. Subjective/quantitative etc.

2. How rewards should been tied to the performance evaluation

3. What the level of pay should be. This level of pay depends heavily on the labor market competition and the level of employee skills that the firm is looking for.

Incentive intensity

The optimal commission rate is exactly the same as the value of the extra output of the employee. Because this motivates the employee to balance the marginal revenues against the marginal costs

B = revenue – marginal costs = marginal profit on next sale

Pay= A + profit from employee’s effort

So, in the situation of optimal commission, all the incremental profits from his effort are given to the employee.

With this incentive system, the firm’s profit looks like this:

Firm’s profit = profit from employee’s effort – pay =  -A

The only way for a firm to make any profit is by paying their employees a negative base salary.In general, jobs with a higher pay for performance have a lower base salary. But these jobs with higher incentive intensities will tend to give a higher total pay.

There are three reasons for this:

1. The employee is motivated to work harder, and in turn compensated for this higher effort though the incentive intensity.

2. Higher incentive intensities will attract the better employees for the job. Because better employees have higher market value, the firm has to pay them more.

3. Higher incentive intensities are riskier, and therefore employees will have to be paid a higher pay to compensate for this risk.

Effect of imperfect evaluations

It is almost impossible to have a performance measure that is completely free of errors. With pay for performance, the employee is also rewarded or punished for these thing that are uncontrollable for him.  This amount of risk influences the payment and the optimal incentives.

Employees are in general risk averse. Therefore, this risk are psychological costs for them. The disutility of risk can be described as:

Disutility from risk = ½ * R * σ2/pay

R = risk aversion of the employee. A higher value of R indicates that the employee is more risk averse.

• Total cost of employee = C (disutility of effort) + ½ * R * σ2/pay

To motivate the employee to do him work good, the firm has to compensate for both the disutility for effort and the extra risk.

• The higher the change of errors, the higher the risk premium that should be paid. Therefore is it very important for employees to do their performance measure carefully.

• The stronger the incentive intensity, the riskier the incentive system is for the employee. Therefore the compensation costs raise because of a higher risk premium.

Effect of distortion

Another problem of performance evaluation is that it almost always involves distortion. Having strong incentives on some tasks but not on other will result in that the employee will just pay attention to those tasks that effects the evaluation. Therefore, there should be given balanced incentives to the different tasks. Thereby, the firm should take into account the relative value of the different tasks. And the more complex the job, the better it is to make use of more subjective measure.

To conclude, to find the optimal intensity of incentives the firm should take into account the following factors:

• Value of employees effort

• Importance of sorting à self selection with recruitment

• Measurement error

• Risk aversion

• Trust and subjectivity

• Distortion

• Potential manipulation

Different pay for performance forms

Besides the simple pay for performance form in the beginning, there are a lot of other options.

Reward vs. penalty

Rewards: employee get a base salary and extra bonus if performance arise above a certain level.

Penalty: employee get a base salary but the reward is reduced if the performance fall below a certain level.

• The employee has no incentive anymore to work harder when he performs above the certain level

Important in both cases is to determine the ideal ‘certain level’. In the case of rewarding, if this level is too high, the worker will have a lower incentive. In the case of penalty, if this level is too low, the worker will have a lower incentive.

Besides that, if the employee already work longer in the firm, you may want to change this level because of the learning effect or because the working methods have been changed (=ratchet effect). But changing this level can be tricky, because the employee will not be happy with the change and incentives will be reduced.

Lump sums

If performance is above an certain level, there is a jump in reward. An example of this is promotion. Another example is a lump sum bonus, a fixed amount of money if the performance meets a certain target. Such a system gives a very high incentive if the employee is near the target, but if he is too far below it or already above, the incentive will be low.

Reward plan with a cap

Here is made use of the reward plan but with a cap; a maximum amount of rewards that an employee can earn. A cap can reduce incentives, especially for very high performers. But a cap can be useful when it is plausible that luck or manipulation has a high influence on the reward system.

Profit sharing

With a profit sharing plan, firm profits are used as performance measure. But this is not a good performance measure for most employees and will therefore provide almost no incentive.

• Firms profit is most of the time uncontrollable for employees.

• Free rider effect

But why are there still firms that make use of the profit sharing plan:

• Peer pressure can reduce the free rider effect

• When firms make extensive use of teamwork, group based incentives work better than individual incentives.

• It lowers the financial risk of the firm

A common critic on pay for performance is that is reduced the intrinsic motivation of employees.

11: Promotion as incentive

Long-term career perspective can be an important intrinsic motivation for people. Especially in the form of promotion, because this brings increases in rewards.

Promotion

Promotion can be given to two types of employees:

• Promotion can be given to the best performing employee at the lower level. In this case, the promotion is a sort of incentive.

• Promotion can be given to the employee who is likely to perform the best at the higher level job. In this case, promotion is used to sort people into jobs that fits best with their skills.

These two things will conflict if the best performer at the lower level is not the same employee as those who is likely to perform best at the higher level. If this is the case, it is better for the firm to promote those who are the best at the higher level and provide other incentives for those who perform best at lower levels, for example by increasing their wage or give them more responsibility.

The way a firm has organized their promotion and compensation structure, does not depend on incentives effects alone.

• Important is the external labor market. Because employee may easily change to a similar job in another firm.

• The firm’s ability to alter the hierarchical structure are limited.

Therefore, often are promotion and compensation systems not designed to work as an incentive. But promotions are very often an accidental incentive system that comes up, even if the firm does not want to use this for incentives. The incentives from promotion are then a side effect of the sorting process.

Promotion requirements

If a firm would be completely flexible in deciding how to compensate employees at different hierarchical level in the organization, decisions who to promote could be based on two different rules:

• Tournament: a firm promotes a fixed amount of employees who are the best performers.

• Absolute standard: a firm promotes all employees whose performance meets a fixed standard.

There are a variety of differences between the tournament and the absolute standard:

• Quality vs. fixed job slots

• Tournament: this is the best approach if there is an organizational hierarchy with fixed job slots.  An absolute standard is not useful if you need just one CEO.

• Absolute standard: this approach is most useful if the quality of the employees is very important; you will only promote those who are good enough for the higher level job.

While with a tournament, sometimes you will promote someone who does not have the needed skills for the higher level job (but promoted just because he is the best) and sometimes you will not promote people who are really good for the job (just because they are not the best), which can lead to turnover of these people.

• Performance evaluation

• Tournament: employee’s performance is evaluated relatively to his competitors; relative performance evaluation (RPE).

• Absolute standard: performance is evaluated for the individual employee.

• Objectivity of the evaluation

• Tournament: it is easier to evaluate in the case of a tournament, because you just have to look at who is the best and you do not have to decide how good you have to perform. This is an example of ordinal ranking, just the order matters, not the distance between the competitors.

• Absolute standard: It is much harder to evaluate how much each employee has performed.

• Risk

• Tournament: RPE reduces measurement risk if common risks (that both employees have) is more important for performance evaluation than idiosyncratic risk (that differs between both employees).

• Absolute standard:  absolute standards reduces measurement risk if common risks (that both employees have) is less important for performance evaluation than idiosyncratic risk (that differs between both employees).

• Distortion

• Tournament: relative performance evaluation can distort an incentive for employee to work together with others.  RPE is less likely to work effective if employees have interdependent jobs. There is more incentive to sabotage. This can be reduced if they also pay attention to performance measures as cooperation and sabotage in the evaluation, or even performance of your colleagues. But this will reduce distortion, but increase risk because you cannot control what your colleagues do. 

• Absolute standard: there is no incentive to sabotage if the performance evaluation is based on the individual performance.

Promotion incentives

Incentives depends on two factors:

• How effort influences the evaluation

• How evaluation influences the compensation

Salary

The most important promotion incentive is the change in salary. The relationship between pay and performance is a greater incentive than the level of pay on its own. The firm has usually two different instruments in designing the pay package of their employees.

• Base salary: to recruit and retain the needed quality of employees. The base salary depends on the labor market supply and demand for that level of employees. Besides that, it depends on the level of effort and risk of the incentive system.

• Vary pay with performance: firms can make use of this flexibility to ensure appropriate incentives.

Prize for promotion

• Direct effect: Employees are willing to provide more effort, if the raise that can be earned with promotion is high. The raise and the longer term rewards that comes with promotion are higher in higher levels of the hierarchical structure of the firm. Therefore, incentives will be larger at higher levels.

• Indirect effect: an indirect benefit from promotion is the ability to compete for the next promotion. This incentive effect will be less than the direct effect, because this next promotion is not guaranteed and they first have to deliver extra effort to reach it.

But this explains that compensation at higher levels in the hierarchy already affects incentives at lower levels in the hierarchy. So, the higher the raise in pay between level 6 & 7 in the firm, the larger the incentive will be at all levels from 1 till 6. Therefore, it is more effective for an firm to have large raise in wages at higher levels in the organization.

Probability

There will only be an incentive for exerting effort if promotion is possible, but not too hard or too easy to achieve. Incentives are driven by the effect of extra effort on the chance of getting promotion. On the other hand, employees has incentives to slack off if the chance of winning is very low, when the chance on promotion is very high. Therefore, the probability of promotion should be less then ½, especially for higher levels in the hierarchy.

Luck

Luck, even good or bad, also affects the promotion incentives. Luck reduces the influence of effort on the performance. Therefore, if the risk of luck is higher, the measurement error is higher and the incentive to increase effort will be low.

There are several solution to overcome this problem of lower incentive because of the effect of luck on performance measurement:

• Make cost to ensure that performance is measured more carefully

• Increase the size of the prize; optimal prize structures when luck plays a greater role should include larger rewards for better performers. Thus, variance in salary structures should be higher if luck is higher.

Variety in employees

All the theories above assume that all employees who are hoping for promotion are the same. But these employees can vary on different points, which can cause problems for promotion based incentives.

• Variety in ability: if employees are different in ability, then they will also vary in the likelihood that they will get promotion. Those who have the highest ability will have a good chance of winning promotion, which can lead to a lower incentive. Those with very low ability will have a less chance on winning promotion and may slack off. The employees who think that they have a chance somewhere between getting promotion or not getting promotion will have the greatest incentives.

If a firm uses a standard for promotion, they can vary the threshold level for getting promotion for different employees. For better employees, this threshold should be higher than for less able employees. But this can have a negative effect on sorting.

But this problem is less likely to occur at higher levels in the organization, because these are already promoted employees, and are therefore more homogeneous.

But supervisors can also increase their incentives by given feedback on their performance. Because evaluation is mostly based on subjective assessment of the performance of the employee, the supervisor can manipulate this. The supervisor can increase incentive by giving employees who are performing above the threshold less positive feedback than they deserve , moving them to the threshold and increasing their incentives. The supervisor can increase incentives by giving low performing employees better feedback than they deserve, so they come closer to the threshold and increasing their incentives.

• Variety in personality: if people who are less likely to cooperate (aggressive) have to work together with people who prefer teamwork (doves), in a workplace were rewards are competitively awarded, problems can arise. If these people have to work together and there is a tournament type reward, the aggressive ones are even more likely to cooperate less and sabotage more. This effect will be less if aggressive people have to work together with each other and doves have to work together, because then they both have to compete with other employees with the same personality.

• Incentives for those who do not have prospect for promotion: people who do not have prospects for promotion have lower extrinsic motivation and are therefore relatively unproductive. The firm can do several things for such workers:

• Encourage these employees to leave the firm

• Find a more suitable job for the employee in the firm

• Provide another sort of incentive; for example stronger pay for performance

• Increase intrinsic motivation

• Hiring from outside the firm: hiring employees from outside has several effects on promotion based incentives:

• Lowers the incentives for internal candidates because it decrease the likelihood that the employee will earn the promotion.

• Using outside hiring combined with a tournament can increase the benefits; relative ranking is used, but in years of bad quality inside the firm, the firm can decide to hire externally.

Turnover

The higher the turnover in the firm, the more open jobs slots are available. This increases the promotion incentives. Thus, make sure that there is a healthy degree of turnover in the firm can be very useful.

Career concerns

If the labor market is active, employees can be more motivated because good performance may lead to better job offers outside their current firm. This is especially the case if human capital is more general and where other employers can evaluate their performance.

• Employees are more likely to be motivated in the early years of their career, to improve their reputation in the labor market

• Later in their career, employees are less motivated because more is already known about their capabilities so there is less possibility to affect the market value

• Young employees are more likely to take risks, because if the risk do not work out well, they have more time to recover from bad results.

Senior incentives

Increasing earnings are not just an effect of promotion but also from increasing salary over the time. Seniority plays a role in salary increases and can also be used as a long term incentive. By pay a lower wage at the beginning of the career and increasing this with seniority, the stronger the incentive is to provide high effect. This is because the employees are more willing to stay longer in the organization, because highest gains are there in the end. If the earnings are always the same, the employee will be less willing to provide effort near the end of the retirement, because the disadvantages of firing decrease.

One problem with increasing pay with seniority is that employees may be willing to stay at the firm after retirement. But this is inefficient for the company. One way to solve this is to let the worker promise to retire at a certain date, fire the employee, resort other incentives (pensions) or imposing mandatory retirement.

12: Executive compensation

Stock options

Call option: a financial security that gives the owner of the option the right to purchase a share of a company’s stock, at a fixed exercise price. Stock is actually a special kind of call option, with an exercise price of zero. If the price of the stock is below the exercise price, it would not make sense to exercise the option. It the price of the stock is above the exercise price, the holder of the option can make a profit (as high as the difference between the two prices), by exercising the option and selling the stock.

Put option: a financial security that gives the owner the right to sell one share of a company’s stock at a fixed exercise price. Exercising the put would be beneficial if the stock price fell, the opposite of the call option.

Because owners of calls hope that the stock rise in value, employee stock option are always calls. This chapter will just focus on these call options.

• If the exercise price exceeds the stock price, the option is out of money. The option should not be exercised, so the payoff is zero.

• If the stock price exceeds the exercise price, the option is in the money. If the option is exercised and the stock sold, the profit is as high as the difference between those two prices. This payoff is the intrinsic value of the option.

If an employee gives an option to the employees, these are almost always issued at the money (stock price=exercise price). Besides that, the options have an expiration date, which is the last date on which the option can be exercised.

There are several differences between stock options and options that are traded on exchange:

• An employee cannot trade an option. He can just hold the option or exercise it.

• If an employee leaves the firm, all unexercised options lose their value.

Benefits of employee stock options

• Cheap form of financing: the firm can offer options instead of salary, with zero payout of actual cash. Therefore, options have a zero short-term impact. This is especially beneficial for startup companies, for who outside financing may be very difficult to obtain.

But for most firms are stock options a poor way to raise funds. For most employees, the stock options are a substantial part of their wealth. Therefore, these employees will be quite risk averse; more than typical investors who have a portfolio of companies. The employees will demand a larger risk premium in order to be willing to hold the options, which increase the firm’s costs.

• Self-selection: options will self select the employees who are most optimistic about the firm’s prospects and who believe that they can improve this performance. Besides that, options tend to encourage employees to take more risks on the job. Risk can increase performance and thereby the payoff. If the risk results in bad performance, the downsides of option pay a little. If this risk taking behavior is beneficial for the firm, depends on the situation.

• Reducing turnover: employee options reduce turnover because an employee have to give up his options if he leaves the firm.

Incentives from employee options

Another important argument for employee options is that is provides incentives.

• Performance measure:

• stock price is a very broad measure, which can distort incentives.

• Stock price is a very risky measure, and therefore should the firm pay the employee a relatively high risk premium.

• Stock price is largely uncontrollable for the employee, and will therefore generate almost no incentive

• Pay for performance:

• if options are not too far out of money: for the small amount of key employees for who stock value is a good performance measure, a strong pay for performance relation can be achieved with options, because they only pay off when the stock price exceeds the exercise price.

• If the options are too far out of money: then the pay for performance relationship falls. Because the increased effort of employee is not likely to raise the stock price above the exercise price (the price where the employees are earning money again). Because option are sometimes a big amount of their compensation, when option are out of money, their compensation fall dramatically. In this case the firms maybe have to re-price the options, offer other forms of compensation or suffer turnover.

• Stock options do not have a downside for employees. So the employee do not have a downside risk from options.

• Options over time:

• Give all options at once: this gives the highest incentive immediately. But also the incentives and the value of the pay package decrease enormous if the stock price falls.

• Give options over a period of time: there are two approaches to do this:

• Give a fixed value of options each year: employees get less options if the firm is performing well (and stock price is high) and more options if the firm is performing bad (and stock price is low). Therefore, the total compensation is more predictable.

• Give a fixed amount of options each year: this makes the total compensation for the employee more variable and increases thereby the incentives.

• Options are especially useful in startup companies. As said before, options are an incentive for taking risk, because good performance is rewarded, but bad performance does not have a downside risk.

For startup firms it is also beneficial to take risk, because they have less to lose (no brand name or reputation yes) and a lot to gain if the risk take turns out successful.

On the other hand, options are not useful in companies where there is little value as result of good performance and high downsides of bad performance.

• Options are probably the most expensive form of compensation. This is because they are one of the riskiest forms of pay for performance. Therefore, employees are asking for a high risk premium. If the firm had sold the options to the open market, he would have saved this risk premium.

Executive pay

In this part we consider the pay for performance issues for CEOs and top executives. The general assumption is that the goal of these executives is to maximize shareholder value.

Executive pay is much discussed recently, and criticized for several reasons:

• Executives are paid too much

• Executive pay does not reflect performance

• CEOs take advantages of their position; they use their power to get higher levels of compensation than they would otherwise get. This can happen if the CEO has influence on who is hired as compensation committee.

Pay for performance

The most important performance measure for executives is the stock price. This measure is reasonable because they can strongly affect the value of the firm. But it is also risky. The optimal incentive intensity should not be based on the total firm value, but on the employee’s contribution to the firm value.  Therefore, many executives compensation packages are also based on narrower performance measures.

In general, the incentive intensity for CEO compensation is very small. This suggest that risk, luck and other factors also play an important role.

While it is difficult to say what the right incentive intensity should be, there are some patterns.

• Incentive intensity is stronger when stock price is less risky

• Incentive intensity vary between industries; lower in regulated utilities

• Incentive intensity is weaker in larger firms. The relationship between executive pay and firm performance is weaker in larger firms.

Executive incentives

Besides pay for performance, there are four other factors that have an important effect on executive behavior:

• Stakeholders’ pressure: this is only beneficial for an organization if the shareholders are well informed.

• Market competition: the more competition, the higher the pressure on the organization to increase performance and be innovative.

• Market for corporate control: if a publicly traded firm is badly managed, the management can be replaced.

• Oversight by the board of directors: This oversight arises from the separation of ownership and control. The board of directors should advice and support the management team and should provide a last line of decision control. So, the board of directors should evaluate executive performance, and reward or punish them based on these evaluations. Therefore, CEOs often try to fill in the board of directors with sympathetic directs.

• However, the governance is not perfectly working in this way, it is an important tool to exert some power over the management.

It is very important to align the interest of the firm to the interest of the employees, by asking the management what their intrinsic goals are. Because there can be a substantial loss of value when companies do not pay enough attention to incentives for the top management. On the other side, the firm of the value can increase enormous by performance increases if management incentives are well designed.

13: Benefits as part of compensation

Relation between wages and benefits

Benefits are an important part of compensation. Benefits include:

• Health insurance

• Pension

• Paid time off

• Child care

• Subsidized meals etc.

Important is why firms do offer benefits as a part of compensation. And what should be the ratio between benefits and cash compensation.

It is difficult to depend what amount of benefits should be given to employees. This is especially because it depends per employee how high they value the benefits. The value is the amount of money that the employee is willing to pay to get that particular benefit.

It is possible that the employee value the benefit higher than it cost:

• If the employer can buy the benefit cheaper than the individual employee can buy it.

• If there is a tax arbitrage involved.

There are several ways to determine how much value the workforce gives to certain benefits:

• The firm could give the employees the choice between a benefit which is worth an amount X and amount X in cash. For the firm does it not matter, because both options cost the same for the firm. But if the employee values the benefit higher than the employee has to pay for it, the firm gives away too much. Because the employee was willing to pay more than X for the benefit, but have only a decrease in salary of X. 

• Ask the employees. But this would be of little value, because if the employee knows that the employer charge the amount that the employees are saying, they will understate the true value.

• A better option is to use market studies of the relation between wages and benefits.

Benefits advantages

There are several reasons why firms should offer benefits to their employees.

• Cost advantage:

  • Economies of scale: sometimes a firm is able to get goods or services for employees below the market rate because of quantity discount. This is especially the case in larger firms and when the benefits are related to the firm’s area of business.

  • Tax advantage or subsidy: sometimes the government gives subsidies (in the form of tax advantages) to firms to encourage the use of benefits to employees.

• Value advantage

• Sorting: employees vary in their preferences for benefits, so the benefit plans of the firm have an effect on the sorting of employees into the firm. For example by providing life insurance, which is more valued by older worker, the firm will especially attract older employees. The same is for child care, which attracts employees with families. Therefore, benefit plans can be used as a recruiting tool.

• Productivity: Sometimes benefits can increase the employee’s productivity. Example of this are:

  • training.

  • If employees get discount on the firm’s products to ensure that employees buy more often the firm own product, which improve the employee’s understanding of the products, which can improve the productivity when producing or sell this product. 

  • Offering concierge services to employees, to ensure that they have more time to spend on their job.

• Some benefits must the firm provide to the employees, because of the law. Examples are minimum levels of workplace safety and maternity leave.

 Benefit types

Cafeteria plans

Because specific benefits does not suit every employee, more flexibility in benefits is preferred. Cafeteria plans give an employee more flexibility in their benefit choice. Every employee get the same amount of benefit (in costs), but the employee can spent this amount themselves on a variety of benefits. In this way, the benefits give the most value to every individual employee.

One of the most important issues of cafeteria plans is employee sorting. While it does not permit the firm anymore to attract the type of employees that it is looking for (by offering just the benefit that that type is looking for), it can influence the sorting by changing the prices for every benefit, to encourage or disencourage different kinds of employees.

But benefits could also lead to adverse selection. For example, by offering health care insurance, the firm would attract employees who are less healthy. The costs for the firm are higher because they have to pay a lot for the health care of the unhealthy employees, while there are no benefits, because unhealthy employees are not more productive, and maybe even less productive. Therefore, in the case of adverse selection, firms should reduce the employees’ wages enough to cover the costs of the healthcare.

Pensions

In a lot of firms, pension plans are the largest part of benefits. Because of the lack of mandatory retirement in many countries, pensions can be an important tool to affect the retirement behavior.

There are two basic types of pension plans:

• Defined contribution plan: Each pay period the employer pay a contribution to the pension account of the employee. At the moment that the employee retires, the amount on the account is the basis of the pension. Sometimes, the amount is turned over to the employee in one time but it is also possible to pay the employee an amount every year, till the employee dies.

• Defined benefit plan: this type of pension plan is more complicated and diverse. With defined benefit plans, the employee is gets a specified benefit, independent of the amount that is in the fund. The employee’s annual pension payment is defined by a formula. There are two different types of formulas:

  • Pattern plan: annual pension after retirement = specified amount of money * years of service at time of retirement

  • Formula/conventional plan: annual pension after retirement = specified proportion * years of service * final salary average (over some number of final years)

Because this formula plan linked the level of pension benefits to the final salary, it moves with inflation. Another effect is that employees will work harder during their final years because their compensation of these years are linked to their pension.

Different pension plans also affect the turnover rates in a different way.

• Defined benefit plan: In the case of a defined benefit plan, where benefits are not paid at once, but in a specified amount every year, there will be a best time for the employee to retire. This is because if he works short for the firm, he will not gain a large amount because the amount of payment depends on the years of service at the time of retirement. But also working long after your 65^th will be not beneficial, because the employee will get an high amount of money every year, but the years till his death will be lower and therefore there is chance that not the whole pension is paid out by that time. Therefore the value of pension as a function of age of retirement has a parabola (^) shape. The value of retirement at the first day or the day the employee dies will be 0, and somewhere in between is the age with the highest value.

• Defined contribution plan: With defined contribution pension plans, the present value of the pension must rise with the age of retirement. And it does not depend on the number of years left in the employees life, because the whole account is paid out at the moment of retirement. Thus, additional years of work (also after 65) are rewarded.

Because mandatory retirement is outlawed, firms are looking for other ways to push employees to retire. Examples are:

 Window plans: offer employees a payment for direct retirement.

• Replace defined contribution plans for defined benefit plans.

Vesting: another type of pension benefits, that is not directly owned by the employee as soon as they accrue. In this case, the pension benefits may not be vested until the employees has stayed within the firm for a given amount of years.

He accrue an amount of pension from the first year, but if the employee leaves within the given number of years, he will receive none of these benefits. This has an important effect on turnover. Totally in the beginning turnover can be high, because the employee does not fit with the firm. But after the first period turnover will be almost zero till the given amount of years that you have to stay to get your pension. But after this amount of years, the turnover rate increase enormous, because everyone who was waiting to leave, can leave at that moment.

All those examples show how important the pension plan can be for the ages of retirement. But pension plans can also affect people at earlier stages of their career. This is visible in the following concepts:

• Portability: a pension plan that is portable and have values that do not change if the employee changes employer. In order to receive the benefits, the employee should work 40 quarters in the system, but it does not matter for which employee you work and how often you have changed in the meantime. The benefit of the portable pension plan is that the pension benefits will be higher. Another effect is that it increases turnover, because shifting to another firm does not influence the pension benefits anymore. Portable plans are often run by unions.

• Employee stock ownership: employee stock ownership as an incentive is already discussed before. But companies often invest a part of the employee’s pension benefits in company’s stock. But it is not preferable to do so because by doing this, the employer put the retirement benefits of the employees at a risk

Paid time off

Employees get normally around 10 to 15% paid time off for holidays, vacation of sick leave. So employees are full paid for only 85-90% that they are working. But of course, wage rated adjust to compensate for the time off. The firm will offer the employee a higher daily wage with no paid time off or a lower daily wage with paid time off. In fact, there is no difference between those options for the firm and the employee.

But if this choice is available, it would be better to offer the higher daily wage with no paid time off. This is because in the case of a lower wage with time off, the employee will take all these days, even if it is not very valuable for him. This is because if the productivity of the employee is higher than the daily salary of the employee, it is better for the firm that the employee is working. But it is also more preferable for the employee, because he values the salary of a day working higher than a day off, and is therefore more willing to work instead of taking of all free days because he have to because he is not paid for it

But still a lot of firms are paying a fixed salary including some paid days off. There are some reasons for this:

• There is value to the firm in having their employees taking vacation time.

• There may be productivity reasons. This is especially the case if employees work in teams. If the rest of the team has a paid day off, it is not beneficial for the firm that only one team member is working, while he is dependent on the other team members.

14: Entrepreneurs and intrapreneurs

Entrepreneurs

An entrepreneur is someone who sets up his own business or play an important role in a new venture. Important attributes of an entrepreneur are the greater ability to take risks and optimism.

An entrepreneur need a different portfolio of skills than normal employees do, because he is no specialist but has to deal with as well human, financial and physical capital. Besides that, management skills are needed for structuring the organization and leading the employees. But an entrepreneur does not have to be an expert in all these areas, but needs at least some understanding of it to screen and recruit the required employees, to design their jobs, evaluate their performance and coordinate them. But this also applies to top managers, which have therefore also a sort of entrepreneurial type of function.

Choice between entrepreneurs and specialized employee

If there are two skills, an individual can choose for a job that is specialized or choose to become an entrepreneur.

• Specialized employee: Both skills pay the same for each output of the employee. Therefore, if the individual specializes he will choose for the job that matches the best with his skills. Therefore the income of the specialist is the maximum of his skills.

à specialist income = maximum (skill 1, skill 2)

• Entrepreneurs: entrepreneurs needs some ability to perform each task, or to lead others who perform those tasks. Therefore, the value of an entrepreneur depends on the level of both skills that he has, not just their highest level. Thus, the ability of the entrepreneur to do his job good is limited by his lowest skill level.

à entrepreneur income = X * minimum (skill 1, skill 2)

But the entrepreneur income depends also on X. And X stands for different things:

• The relative value of a minimal skill level of the employee in entrepreneurship, compared to the employee’s best skill level in normal employment. Thus, the relative labor market price for broad skills compared to specialized skills.

• X may vary between entrepreneurs; some entrepreneurs can create greater value with the same skill portfolio than others.

So people will decide to become an entrepreneur if:

X * minimum (skill 1, skill 2) > maximum (skill 1, skill 2)

This brings us to two important conclusions:

• The more unbalanced the skills of an individual, the less likely they are that they choose for entrepreneurship. So, balanced skills are an important component of entrepreneurship.

• The larger X is, the more likely that an individual choose to become an entrepreneur.

• X might also include creativity; which is in this context the ability to coordinate people with different sets. If someone’s creativity is uncertain, it can be useful to try out entrepreneurship. If X turns out high, the person remains an entrepreneur, and if X turns out to be low, he turns back to a specialized job.

Entrepreneurs across industries

Entrepreneurship varies between industries because of different reasons:

• Difference in required set of skills: suppose that different industries also require different sets of skills. And this will affect the supply of entrepreneurs to various industries. In an industry with need for a set of skills that a lot of individuals have, it is likely that there a lot of small firms. While in industries with need for a set of skills that almost no one has, there are bigger and fewer firms, with more specialized people working.

• Difference in business process complexity: Some businesses are simple and require a small set of skills, while other are more complex and require larger sets of skills. In the case of three required skills instead of two because of a complex industry, it becomes more beneficial to specialize because of two reasons:

  • In the case of specialization, by adding one more skill, the maximum skill cannot fall, but remains the same or rise because the new skill is higher than the two you already had. So in this case, with more skills you are always better off or remain the same.

  • In the case of entrepreneurship, the minimum skill cannot rise, but only remain the same or be lower because the third skill is lower than the two you already had.

And this argument is the same if you add a fourth skills, and a fifth… etc.

Thus, the more the complex the business, the fewer the supply of entrepreneurs in the industry.

Therefore, in an simple industry with few required skills, there will be a high level of market entry by entrepreneurs, which in turn leads to low economic returns to entrepreneurship. On the other hand, in complex industries there are much lesser new entrepreneurs and therefore very high returns.

Differences in investments in human capital

The choice between becoming a specialized employee or an employee also has effect on the investments in human capital.

If an entrepreneur is going to invest in additional skills, he has three possibilities how to invest:

• Not investing is optimal: if the costs of the additional training are too high. In this case, the market value of entrepreneur is based on the minimum level of skill 1 and skill 2.

• Small investment is optimal: if an individual has less of one skill than another, it is beneficial to invest in the weakest skill till it becomes the same as the other skill. Therefore, becoming less specialized is the best strategy.

• Large investment is optimal: invest first till the two skills are balanced, and after that, make further investments that are balanced between both skills, to get the minimum to a higher level. This is beneficial if the costs of investments are very low or the gains high enough.

Overall, it is always beneficial for an entrepreneur to have a balanced approach to human capital, and therefore always invest in the weakest skill.

Intrapreneurship

As a firm gets larger, it becomes more complex and more bureaucratic. Therefore, they behave normally less entrepreneurially. But many firms are more bureaucratic than is ideal, especially when competition is intense and change is rapid.

Therefore, there are several ways in which a larger firm can encourage intrapreneurship, to become more dynamic.

Independent businesses

By splitting the firm into independent businesses, there is a higher incentive for managers to act like an entrepreneur. By using decentralization and reinforce this with matching performance evaluation and incentives, managers will be more innovative.

• Give managers authority to make decisions. This encourage managers to become more creative.

• Choose performance measures that motivate managers.

But this divisional structure type should only be applied if it matches with the business. For example, if the divisions are very interdependent, decentralization to the division level may cause problems.

Personnel policies

Personnel policies can be rebalanced in several ways to make a firm more dynamic:

• Reducing the hierarchy for decision making to generate and implement more new ideas.

• Take more risk during recruiting. Hire more risky candidates which you keep and promote if they perform well and fire if they do not perform well. This is especially beneficial if small differences in talent bring forward large performance differences, for example in R&D or management positions. This will increase turnover, but this improves innovation because the firm can bring in more new employees with different training and experience.

• Change the incentive system.

• Broader performance measures are more likely to increase creativity. This is for the following reasons:

  • Broader performance measures distort incentives less and are therefore more difficult to manipulate.

  • Broader performance measures are more based on outputs than inputs.

• Subjective performance evaluation is more likely to increase creativity.

  • Subjective performance evaluation make it better possible to reward successful risks, without punishing for unsuccessful risk.

•  Increase the rewards that are given for good performance.

Decision making process

Slow decision making processes make a firm more conservative. This comes from more hierarchy and centralization, because then each decision requires more communication up and down which takes time.

Solutions to speed up the decision making process:

• Decentralizing: decentralizing more decisions may speed up the decision making process. But this does reduce the coordination and control. To reduce the implications of the lack of coordination and control is it possible to only decentralize those decisions that have less impact.

• Spend more resources on decision making to increase the accuracy of the decision making, which may reduce the needed levels of approval stages.

• Make greater investments in information technology. This speed up the communication.

• Make use of standard operating procedures. This can speed up the decision making process because there is no need for communication anymore.

Reduce bureaucracy

Because bureaucracy hinder innovation, it can be beneficial to reduce the bureaucracy of the firm. There are different ways to do this:

• Separate the parts of the firm that are needed for innovation from the rest or the organizational structure. Then it is possible to reduce bureaucracy in only that part of the organization. So, the firm can remain their coordination and control in the rest of the organization.

• Reduce the complexity of the firm’s operations. This can help because complex firms generally use more complex structures, which ask more coordination and control. This can be done in the following ways:

  • Reduce the amount of product lines

  • Outsource noncore activities

Continuous improvements

Constantly adapt the environment to the changing environment. This is making continuous improvements to the existing products or processes, instead of coming up with new products and processes.

• Experimentation: make use of experimentation to test new ideas on small scale before implementing it on large scale.

• Knowledge management systems: to transfer ideas from decentralized parts throughout the rest of the firm.

15: The firm – employee relationship

Economic transaction

Spot markets

Sport markets are perfectly competitive markets. A perfectly competitive market is a market with the following characteristics:

• There is one market price that brings supply and demand in equilibrium. Therefore, negotiation is unnecessary.

• All products of different producers are perfect substitutes of each other. So, product characteristics are not relevant.

• The market is anonymous: suppliers do not know their buyers and buyers do not know their producers.

A perfectly competitive market is of course an idealized model of how real markets work, but it can be helpful to get an insight in how markets works. Besides that, in some cases it is quite a real description of real markets, for example stock markets.

However, few labor markets are looking like such a simple spot markets, since the labor market transactions are one of the most complex types.

Imperfect markets

 Most labor markets are imperfect markets because workers and also the jobs are no perfect substitutes for each other. Therefore, both firms and employees have to make choices about who to hire or for who to work. These choices have effect on the relationship between employees and employers.

• Because there is choice, both employee and employers have to search for a good match, which brings searching costs with it. These search or switching costs are an incentive for both the employee and the employer to continue working together by making multi period offers rather than a repeated set of one period transactions.

• Because employees and jobs differs from each other, there is not one market price. This is also reinforced by imperfect information. Therefore, there will be a range of pay and benefits for similar workers and jobs.

• Imperfect markets introduce bargaining. The relation between employee and firm creates joint surplus (difference between productivity and value to the worker). The actual price of the employee will be somewhere between this difference, but where exactly depends on the bargaining power of both parties.

Communication

Top down communication

A new trend is open book management, in which managers provide their employees with extensive information on the financial condition of the firm. There are several costs by doing so:

• Time is needed to provide the employees with the information and to teach them how to process the information.

• Employees who know everything about the firm may be able to act opportunistically.

But of course there are also advantages:

• Employees may lower their expectations that can help to keep the organization viable. If the organization is doing bad, and the employees are seeing that, they are more willing to accept lower wages. If they do not have the information, they can think that the firm is lying (which in some times will be true and other times not) and will leave the firm.

Thus, it is only beneficial to provide employees with information if employees are leaving when the firm is lowering the wages. If employees are soft, and stay with the firm under these circumstance, there is no need for providing them with information. Because you can not exactly know who are hard and who are soft employees. So providing information is beneficial for a firm under the following conditions:

• When there is a large difference in wage during good times and bad times. When this is large, employees are less willing to believe the firm that the firm is doing bad and accepting the lower wage.

• There is a small difference between the wage paid during bad times at the current firm and the wage paid at the available alternative firm. If employees have good alternatives, they are more willing to leave the firm if this is lowering their wage.

• When the workforce is quite young. Employees who are young have less firm specific capital and therefore more willing to leave the firm.

Bottom up communication

Another benefit of worker empowerment is that employees then are more willing to communicate their views to management. Sometimes employees are not willing to share their preferences with the management, because they are afraid that they will use it against them. But the firm wants to know their preferences because than they can provide compensation packages that better suits what the employee want, which can reduce the overall compensation costs and therefore increase profits.

To encourage that the employee is sharing their preference information, the employee must have some power over the way the information is used, to ensure that it is not used against him.

An alternative for the firm is to ignore the communication and just make assumptions about the employees’ preferences. By offering a certain compensation package, the firm will only attract employees who prefer that package through self selection. But if it also attracts other employees, who are leaving after a short period because they don’t like the package, then is can be costly to replace them, especially when firm specific human capital is invest.

Empowerment

Employees wants power if they have much to lose if they have to move to another job, thus, if their best alternative is lower than their current wage.

• Older workers who have already invested in firm specific human capital

• Upward sloping incentive contracts

• If wages at the current firm are higher than somewhere else.

This creates conflict. The employee wants power, but firms are less likely to give this power because he is overpaying and therefore less afraid that the employee will move to another firm.

Employee empowerment is beneficial for an organization if the employee has firm specific knowledge, which is costly to communicate, and therefore needs decentralization to make use of this knowledge.

So, there are several ways how empowering employees can be beneficial for increasing productivity, but there are also some costs associated with it. Therefore, how should the organization make the empowerment decision?

The criterion for empowerment is to maximize the amount of profit that goes to the firm. The profit of the firm can be calculated by the formula firm’s share * value added by employee. The value added by the employee depends on the employee’s power. But value added is not a good criterion on its own because if the employee’s power is too high, large amount of this value goes to the employee instead to the firm. Therefore,  the firm should  give employees less power than would maximize the added value. The goal is not productivity maximization but profit maximization.

But how much power the firm should give to employees depends on two things:

• When the firm’s share falls more rapidly as a function of employee power, the firm wants lower values of employee power.

• If  the added value of the employee peaks at higher amounts of employee power, the firm will want to give relatively more power to the employee than if this peak is already at lower level of employee power.

Empowerment is likely to reduce capital’s share more if:

• Employees work close together, which make it easier to organize and coerce

• Employees who work a long time for the firm, so they are willing to invest more in increasing their share.

If this is the case, high levels of empowerment will reduce the firm’s profits.

On the other hand, empowerment is likely to increase capital’s share more if:

• Employees have information that is relevant and that the management does not have.

• Employees preferences are not well-known by the management.

Under these conditions, the firm will benefit from giving employees more power.

Coordination

There is potential conflict between the firm and the employees that arises from the desire of both parties to get a larger share of the created value. This is because it is a zero sum game; if one party gains, the other loses by the same amount (so the total amount is constant). This conflict may lead to a loss of value compared with the situation in which both parties cooperate.

But it is possible to make it a non-zero sum game, which makes both parties better off, by letting them cooperate (prisoner’s dilemma)

An example of this prisoner’s dilemma is the investment in firm specific human capital. Both parties are better off if the investment is made. But because there is a risk that the other will renege on their promise later, neither may be willing to cooperate. Then no investment is made, and both parties are worse off. The employee is more likely to make the investment if he expects reciprocity from the firm. Therefore, the reputation of the firm is very important. For the firm is it the same, that depends on the reputation of the employee.

The reputation of the firm depends on:

• History: older firms have most of the time a stronger reputation than very new firm have.

• Consistency: having a long history of behavior, without too much variance, is a good way to build a strong reputation.

• First impression: in the first interactions, a lot of expectancies are already formed. Therefore is it important how the firm treats new employees.

• Other employees: the way how other employees are treated by the firm also affects the reputation of the firm. Therefore is it important for the firm to have good working relationships with all employees. If the trust of one employee is broken, this may harm the trust between the firm and all other employees as well.

• Personality: the personality of a single manager can also affect the firm’s reputation. The trust of employees in that manager can have a huge effect on the expectations for how the firm is going to treat you.