chapter 7

ORGANIZATION FACTORS

Although product and labor market conditions create a range of possibilities within which managers create a policy on external competitiveness, organizational factors influence pay-level and pay-mix decisions, too.32 Industry and Technology - The industry in which an organization competes influences the technologies used. Labor-intensive industries such as education and health care tend to pay lower than technology-intensive industries such as petroleum or pharmaceuticals, whereas professional services such as consulting firms pay high. In addition to differences in technology across industries affecting compensation, the introduction of new technology within an industry influences pay levels. The next time you are waiting in line at the supermarket, think about the pay the checkout person gets. The use of universal product codes, scanners, scales built into the counter, even do-it-yourself checkout lanes have reduced the skills required of checkers. As a result, their average pay has declined over time.33 Qualifications and experience tailored to particular technologies is important in the analysis of labor markets. Machinists and millwrights who build General Electric diesel locomotives in Erie, Pennsylvania, have very different qualifications from machinists and millwrights who build Boeing airplanes in St. Louis.34 Employer Size - There is consistent evidence that large organizations tend to pay more than small ones. A study of manufacturing firms found that firms with 100 to 500 workers paid 6 percent higher wages than did smaller firms; firms of more than 500 workers paid 12 percent more than did the smallest firms.35 This relationship between organization size, ability to pay, and pay level is consistent with economic theory that says that talented individuals have a higher marginal value in a larger organization because they can influence more people and decisions, thereby leading to more profits. Compare the advertising revenue that former Late Night host Stephen Colbert was able to bring to CBS versus the potential revenue to station WBNS if his Late Night show was only seen on WBNS in Athens, Ohio (or even on Comedy Central). No matter how cool he was in Athens, WBNS (and/or Comedy Central) could not generate enough revenue to be able to afford to pay Mr. Colbert his multimillion dollar salary; CBS could. However, theories are less useful in explaining why practically everyone at bigger companies such as CBS, including janitors and compensation managers, is paid more. It seems unlikely that everyone has Colbert impact on revenues. People's Preferences - What pay forms (health insurance, eye care, bonuses, pensions) do employees really value? Better understanding of employee preferences is increasingly important in determining external competitiveness. Markets, after all, involve both employers' and employees' choices.36 However, there are substantial difficulties in reliably measuring preferences. In response to the survey question "What do you value most in your work?" who among us would be so crass as to (publicly) rank money over cordial co-workers or challenging assignments? Researchers find that people place more importance on pay than they are willing to admit.37 Organization Strategy - A variety of pay-level and pay-mix strategies exist. Some employers adopt a low-wage, no-services strategy; they compete by producing goods and services with the lowest total compensation possible. Nike and Reebok reportedly do this. Both rely heavily on outsourcing to manufacture their products. Nike, for example, outsources 99 percent of its footwear production to independent contract suppliers in China, Vietnam, Indonesia, and Thailand, all of which have much lower labor costs than found in the United States. Others select a low-wage, high-services strategy. Marriott offers its low-wage room cleaners a hotline to social workers who assist with child care and transportation crises. English and citizenship courses are available for recent immigrants. Seminars cover how to manage one's paycheck and one's life. Still other employers use a high-wage, high-services approach. Medtronic's "fully present at work" approach, discussed in Chapter 2, is an example of high wage, high services. Obviously, these are extremes on a continuum of possibilities. One study found that like the company in Exhibit 7.3, a variety of pay-level strategies exist within some organizations. Pay levels that lead competition are used in jobs that most directly impact the organization's success (research and development and marketing in pharmacy companies). In jobs with less impact (human resource management and manufacturing), pay levels reflect a "meet competition" policy. As noted earlier, efficiency wage argues that some firms, for a variety of reasons (e.g., their technology depends more heavily on having higher-quality workers or it is more difficult to monitor employee performance) do indeed have efficiency reasons to pay higher wages. Higher pay levels, either for the organization as a whole or for critical jobs, may be well suited to particular strategies, such as higher value-added customer segments.38 (Recall our example of Costco from Chapter 1.) Similarly, evidence suggests that organizations making greater use of so-called high-performance work practices (teams, quality circles, total quality management, job rotation) and computer-based technology and having higher-skilled workers also pay higher wages.39 This is consistent with our discussion in Chapter 2 about the need for human resources practices designed to encourage ability, motivation, and opportunity to contribute (AMO theory) to reinforce each other. The observable benefits of higher wages may include: higher pay satisfaction, improved attraction and retention of employees, and higher quality, effort, and/or performance.40 Ultimately, higher wages must bring something in return (e.g., higher productivity, quality, and/or innovation). Otherwise, a firm's ability to compete and survive is in question. (See our discussion of General Motors and the U.S. automobile industry in Chapter 1 and elsewhere in this chapter.) Evidence shows that in manufacturing, productivity (defined as sales value of production divided by employee hours worked) is positively correlated (r = .45) with hourly wage level.41 Thus, the relationship, while far from perfect, is meaningful in manufacturing.

COMPETITIVE PAY POLICY ALTERNATIVES

Compensation theories offer some help in understanding the variations in pay levels we observe among employers. They are less helpful in understanding differences in the mix of pay forms. Relevant markets are shaped by pressures from the labor and product markets and the organization. But so what? How, in fact, do managers set pay-level and pay-mix policy, and what difference does it make? In the remainder of this chapter, we will discuss those two issues. Recall that pay level is the average of the array of rates inside an organization. There are three conventional pay-level policies: to lead, to meet, or to follow competition. Newer policies emphasize flexibility: among policies for different employee groups, among pay forms for individual employees, and among elements of the employee relationship that the company wishes to emphasize in its external competitiveness policy. What Difference Does the Pay-Level Policy Make? - The basic premise is that the competitiveness of pay will affect the organization's ability to achieve its compensation objectives, and this in turn will affect its performance.51 The probable effects of alternative policies are shown in Exhibit 7.12 and discussed in more detail below. The problem with much pay-level research is that it focuses on base pay and ignores bonuses, incentives, options, employment security, benefits, or other forms of pay. Yet the exhibits and discussion in this chapter should have convinced you that base pay represents only a portion of compensation. Comparisons on base alone can mislead. In fact, many managers believe they get more bang for the buck by allocating dollars away from base pay and into variable forms that more effectively shape employee behavior.52 - General Mills, for example, seeks to pay at the 50th percentile of base salary (among consumer packaged goods companies) but at the 75th percentile for total cash (base salary variable pay) for managers if they have superior performance.53 As Exhibit 7.13 shows, this seems to be a common strategy. Pay with Competition (Match) - Given the choice to match, lead, or lag, the most common policy is to match rates paid by competitors.54 Managers historically justify this policy by saying that failure to match competitors' rates would cause murmuring among present employees and limit the organization's ability to recruit. Many nonunionized companies tend to match or even lead competition in order to discourage unions. A pay-with-competition policy tries to ensure that an organization's wage costs are approximately equal to those of its product competitors and that its ability to attract applicants will be approximately equal to its labor market competitors. Classical economic models predict that employers meet competitive wages. While this avoids placing an employer at a disadvantage in pricing products, it may not provide a competitive advantage in its labor markets. Lead Pay-Level Policy - A lead pay-level policy maximizes the ability to attract and retain quality employees and minimizes employee dissatisfaction with pay. It may also offset less attractive features of the work, à la Adam Smith's "net advantage." Combat pay premiums paid to military personnel offset some of the risk of being fired upon.55 The higher pay offered by brokerage firms offsets the risk of being fired when the market tanks. As noted earlier, sometimes an entire industry can pass high pay rates on to consumers if pay is a relatively low proportion of total operating expenses or if the industry is highly regulated. But what about specific firms within a high-pay industry? For example, Merrill Lynch adheres to a pay leadership position for financial analysts in its industry. Do any advantages actually accrue to Merrill Lynch? If all firms in the industry have similar operating expenses, then the lead policy must provide some competitive advantage to Merrill Lynch that offsets the higher costs. A number of researchers have linked high wages to ease of attraction, reduced vacancy rates and training time, and better-quality employees.56 Research also suggests that high pay levels reduce turnover and absenteeism.57 Exhibit 7.14 summarizes several studies on the degree to which higher pay is associated with lower quits (turnover). These studies suggest that pay level can have a substantial influence on quit rates. As noted above, pay satisfaction helps explain the influence of pay level on quits. Exhibit 7.15 shows the relationship of pay satisfaction with turnover (quits) and also determinants of pay satisfaction. In addition to pay level, we see, consistent with equity theory, that fairness/justice perceptions, both distributive (based on how much they receive) and procedural (what process was used to decide how much), matter.58 Nevertheless, there is no simple relationship between pay level and financial performance. Several studies have found that the use of variable pay (bonuses and long-term incentives) is related to an organization's improved financial performance but that pay level is not.59 We have conjectured that pay level is so important that paying "too low" or "too high" for any extended period has such significant potential drawbacks that organizations do not differentiate much on pay level (alone). It may be that high pay levels have beneficial effects on performance only when the pay level itself depends on performance (i.e., there is a high pay level AND strong pay for performance).60 A lead policy can also have negative effects. It may force the employer to increase wages of current employees too, to avoid internal misalignment and murmuring. Additionally, a lead policy may mask negative job attributes that contribute to high turnover later on (e.g., boring assignments or hostile colleagues). Remember the managers' view mentioned earlier that high turnover was more likely to be a managerial problem than a compensation problem.61 Lag Pay-Level Policy - may increase employee commitment and foster teamwork, which may increase productivity. How long this promise works, in the face of flat or declining stock markets, is unknown. Unmet expectations probably have negative effects. Additionally, it is possible to lag competition on pay level but to lead on other returns from work (e.g., hot assignments, desirable location, outstanding colleagues, cool tools, work/life balance). Different Policies for Different Employee Groups - In practice, many employers go beyond a single choice among the three policy options. They may vary the policy for different occupational families, as did the company in Exhibit 7.3. They may vary the policy for different forms of pay, as did the companies in Exhibit 7.4. They may also adopt different policies for different business units that face very different competitive conditions. Not by Pay Level Alone: Pay-Mix Strategies - Thus far, we have devoted limited attention to pay-mix policies. Some obvious alternatives include performance driven, market match, work/life balance, and security. Exhibit 7.16 illustrates these four alternatives. Compared to the other three, incentives and stock ownership make up a greater percent of total compensation in performance-driven policies. The market match simply mimics the pay mix competitors are paying. How managers actually make these mix decisions is a ripe issue for more research. How managers position their organization's pay against competitors is changing. Some alternatives that are emerging focus on total returns from work (beyond financial returns) and offering people choices among these returns. Rather than "flexible," perhaps a better term would be "fuzzy" policies. Such pay-mix policy alternatives exist among enterprises in other countries, too. Apache Footware, located in Quingyuan, China, offers base plus bonus, which matches local practice. It also offers benefits that include a new medical clinic, housing for married couples, a school, sports facilities, and a shopping mall. Steve Chen, Apache's chief executive, states, "It's not just about pay, it's about lifestyle. We're building a community so people will stay." (Reminiscent of SAS, whose strategy was discussed in Chapter 2.) In contrast, Top Form Undergarment Wear, located in the same region, phased out its employee housing. It opted to pay employees over 20 percent higher base pay than local practice. Top Form executive Charles Lee says, "Workers need to have a life of their own. They are not children. We pay them more and let each worker decide what is best for them."62 Employer of Choice/Shared Choice - Some companies compete based on their overall reputation as a place to work, beyond pay level and pay mix. For example, IBM compares within the information technology marketplace and positions its pay "among the best" in this group. Further, it claims to "strongly differentiate based on business and individual results." It leads the market with its strong emphasis on performance. IBM also offers extensive training opportunities, challenging work assignments, and the like. In a sense, employer of choice corresponds to the brand or image the company projects as an employer. Shared choice begins with the traditional alternatives of lead, meet, or lag. But it then adds a second part, which is to offer employees choices (within limits) in the pay mix. This "employee as customer" perspective is not all that revolutionary, at least in the United States. Many employers offer choices on health insurance (individual versus dependent coverage), retirement investments (growth or value), and so on. (See flexible benefits in Chapter 13. See also Chapter 2 for how Whole Foods uses an employee vote every three years in choosing its benefits package.) More advanced software is making the employee-as-customer approach more feasible. Mass customization—being able to select among a variety of features—is routine when purchasing a new laptop or auto. It is now possible with total compensation, too. Does offering people choices matter? One risk is that employees will make "wrong" choices that will jeopardize their financial well-being (e.g., inadequate health insurance). Another is the "24 jars of jam" dilemma. Supermarket studies report that offering consumers a taste of just a few different jams increases sales. But offering a taste of 24 different jams decreases sales. Consumers feel overwhelmed by too many choices and simply walk away. Perhaps offering employees too many choices of different kinds of pay will lead to confusion, mistakes, and dissatisfaction.63 An example of a company that does give employees a choice in pay mix is Netflix. Each November, employees have their performance evaluations. In December, each employee chooses how much compensation to receive in cash and how much to receive in stock options. Roughly two-thirds of Netflix employees choose 100 percent cash. Of the remaining one-third, the average share of compensation taken in the form of stock options is 7 to 8 percent. (The share allocated to options was initially restricted, but no longer is. So, these results may change.) The apparent preference among most employees for cash rather than (more risky) options at Netflix is consistent with agency theory, which is covered in Chapter 9.64 Pitfalls of Pies - The pie charts in Exhibit 7.16 contrast various pay-mix policies. However, thinking about the mix of pay forms as pieces in a pie chart has limitations. These are particularly clear when the value of stock is volatile. The pie charts in Exhibit 7.17 show how a well-known software company's mix changed after a major stock market decline (stock prices plummeted 50 percent within a month). Base pay went from 47 to 55 percent of total compensation, whereas the value of stock options fell from 28 to 16 percent. (The reverse has happened in this company, too.) The mix changed even though the company made no overt decision to change its pay strategy. But wait, it can get worse. One technology company was forced to disclose that three-quarters of all its stock options were "under water," that is, exercisable at prices higher than the market price. Due to stock market volatility, the options had become worthless to employees. So what is the message to employees? To competitors? The company's intended strategy has not changed, but in reality the mix has changed. So the possible volatility in the value of different pay forms needs to be anticipated. - Some companies prefer to report the mix of pay forms using a "dashboard," as depicted in Exhibit 7.18. The dashboard changes the focus from emphasizing the relative importance of each form within a single company to comparing each form by itself to the market (many companies). In the example, the value of stock options is 79 percent of competitors' median, base pay is at 95 percent of competitors' median, and overall total compensation is 102 percent of (or 2 percent above) the market median. Pies, dashboards—different focus, both recognizing the importance of the mix of pay forms. - Keep in mind that the mix employees receive differs at different levels in the internal job structure. Exhibit 7.19 shows the different mix of base, cash incentives, and stock programs Merrill Lynch pays at different organization levels. Executive leadership positions receive less than 10 percent in base, about 20 percent in stock, and the rest in annual incentives. This compares to 50 percent in base, 40 percent in annual incentives, and 10 percent in stock for mid-level manager/professional positions, and 80 percent base, 20 percent incentives, and no stock for entry- and lower-level jobs. While the percentages vary among organizations, greater emphasis on performance (through incentives and stock) at higher levels is common practice. This is based on the belief that jobs at higher levels in the organization have greater opportunity to influence organization performance.

CONSEQUENCES OF PAY-LEVEL AND PAY-MIX DECISIONS: GUIDANCE FROM THE RESEARCH

Earlier we noted that external competitiveness has two major consequences: It affects (1) operating expenses and (2) employee attitudes and work behaviors. Exhibit 7.20 summarizes these consequences, which have been discussed throughout this chapter. Efficiency - A variety of theories make assumptions about the effects of relative pay levels on an organization's efficiency. Some recommend lead policies to diminish shirking and permit hiring better-qualified applicants. Others—such as marginal productivity theory—recommend matching. One study, using utility theory, concluded that a lag pay-level policy was the best choice for bank tellers.65 However, as we will see in Appendix 7-A, utility theory tells us that for higher impact jobs, the conclusion could differ. No research suggests under what circumstances managers should choose which pay-mix alternative. Which Policy Achieves Competitive Advantage? - Research on the effect of pay-level policies is difficult because companies' stated policies often do not correspond to reality. For example, HR managers at 124 companies were asked to define their firm's target pay level. All 124 of them reported that their companies paid above the median!66 Beyond opinions, there is little evidence of the consequences of different policy alternatives. We do know that pay level affects costs; we do not know whether any effects it might have on productivity or attracting and retaining employees are sufficient to offset costs. Nor is it known how much of a pay-level variation makes a difference to employees; will 5 percent, 10 percent, or 15 percent be a noticeable difference? Although lagging competitive pay could have a noticeable reduction in short-term labor costs, it is not known whether this savings is accompanied by a reduction in the quality and performance of the workforce. It may be that an employer's pay level will not gain any competitive advantage; however, the wrong pay level may put the organization at a serious disadvantage. Similarly, we simply do not know the effects of the different pay-mix alternatives or the financial results of shifting the responsibility for choosing the mix to employees. Perhaps it is the message communicated by pay mix and levels that is the key to achieving competitive advantage. So where does this leave the manager? In the absence of convincing evidence, the least-risk approach may be to set both pay level and pay mix to match competition. An organization may adopt a lead policy for skills that are critical to its success, a match policy for less-critical skills, and a lag policy for jobs that are easily filled in the local labor market. An obvious concern with flexible policies is to achieve some degree of business alignment and fair treatment for employees among the choices. (The appendix to this chapter shows how utility analysis can help evaluate pay-level strategies.) Fairness - Satisfaction with pay is directly related to the pay level: More is better.67 But employees' sense of fairness is also related to how others are paid. A friend at Stanford claims that if all but one of the faculty in their business school got $1,000,000 and one person received $1,000,001, the others would all be lined up at the dean's office demanding an explanation. Employers have many choices about how and where to invest their resources. Even if the decision is made to invest in improving people's feelings about fairness of their pay, there is little research to tell us this will improve employees' overall feeling about fair treatment in the workplace.68 Compliance - It's not enough to say that an employer must pay at or above the legal minimum wage. Provisions of prevailing wage laws and equal rights legislation must also be met. In fact, we will return to the subject of market wages again when we discuss pay discrimination and the concept of "living wage." In addition to pay level, various pay forms are also regulated. Pensions and health care are considered part of every citizen's economic security and are regulated to some degree in most countries. This is discussed again when we look at international practices and benefits. Employers must also exercise caution when sharing salary information to avoid antitrust violations.69 No matter the competitive pay policy, it needs to be translated into practice. The starting point is measuring the market through use of a salary survey. For this, we turn to Chapter 8.

LABOR MARKET FACTORS

Economists describe two basic types of markets: the quoted-price market and the bourse. Stores that label each item's price or ads that list a job opening's starting wage are examples of quoted-price markets. You cannot name your own price when you order from Amazon, but at Priceline supposedly you can. However, Priceline does not guarantee that your price will be accepted, whereas an Amazon order arrives in a matter of days. In contrast with Amazon's quoted price, eBay allows haggling over the terms and conditions until an agreement is reached; eBay is a bourse. Graduating students usually find themselves in a quoted-labor market, though minor haggling may occur.12 In both the bourse and the quoted market, employers are the buyers and the potential employees are the sellers. If the inducements (total compensation) offered by the employer and the skills offered by the employee are mutually acceptable, a deal is struck. It may be formal contracts negotiated by unions, professional athletes, and executives, or it may be a brief letter or maybe only the implied understanding of a handshake. All this activity makes up the labor market; the result is that people and jobs match up at specified pay rates. How Labor Markets Work - Theories of labor markets usually begin with four basic assumptions: 1. Employers always seek to maximize profits. 2. People are all the same and therefore interchangeable; a business school graduate is a business school graduate is a business school graduate. 3. The pay rates reflect all costs associated with employment (e.g., base wage, bonuses, holidays, benefits, even training). 4. The markets faced by employers are competitive, so there is no advantage for a single employer to pay above or below the market rate. - Although these assumptions oversimplify reality, they provide a framework for understanding labor markets. - Organizations often claim to be "market-driven"; that is, they pay competitively with the market or even are market leaders. Understanding how markets work requires analysis of the demand and supply of labor. The demand side focuses on the actions of the employers: how many new hires they seek and what they are willing and able to pay new employees. The supply side looks at potential employees: their qualifications and the pay they are willing to accept in exchange for their services. Exhibit 7.6 shows a simple illustration of demand and supply for business school graduates. The vertical axis represents pay rates from $25,000 to $80,000 a year. The horizontal axis depicts the number of business school graduates in the market. The line labeled "Demand" is the sum of all employers' hiring preferences for business graduates at various pay levels. At $80,000, only a small number of business graduates will be hired, because only a few firms are able to afford them. At $25,000, companies can afford to hire a large number of business graduates. However, as we look at the line labeled "Supply," we see that there aren't enough business graduates willing to be hired at $25,000. In fact, only a small number are willing to work for $25,000. As pay rates rise, more graduates become interested in working, so the labor supply line slopes upward. The market rate is where the lines for labor demand and labor supply cross. In this illustration, the interaction among all employers and all business graduates determines the $40,000 market rate. Because any single employer can hire all the business graduates it wants at $40,000 and all business graduates are of equal quality (i.e., assumption 2 above), there is no reason to pay any wage other than $40,000. Labor Demand - If $40,000 is the market-determined rate for business graduates, how many business graduates will a specific employer hire? The answer requires an analysis of labor demand. In the short term, an employer cannot change any other factor of production (i.e., technology, capital, or natural resources). Thus, its level of production can change only if it changes the level of human resources. Under such conditions, a single employer's demand for labor coincides with the marginal product of labor. - The marginal product of labor is the additional output associated with the employment of one additional person, with other production factors held constant. - The marginal revenue of labor is the additional revenue generated when the firm employs one additional person, with other production factors held constant. Marginal Product - Assume that two business graduates form a consulting firm that provides services to 10 clients. The firm hires a third person, who brings in four more clients. The marginal product (the change in output associated with the additional unit of labor) of the third person is four clients. But adding a fourth employee generates only two new clients. This diminishing marginal productivity results from the fact that each additional employee has a progressively smaller share of the other factors of production with which to work. In the short term, these other factors of production (e.g., office space, number of computers, telephone lines, hours of clerical support) are fixed. Until these other factors are changed, each new hire produces less than the previous hire. The amount each hire produces is the marginal product. Marginal Revenue - Now let's look at marginal revenue. Marginal revenue is the money generated by the sale of the marginal product, the additional output from the employment of one additional person. In the case of the consulting firm, it's the revenues generated by each additional hire. If each new client generates $20,000 in revenue, then if the third employee has four clients, that will generate $80,000 in additional revenue. But perhaps the fourth employee will only be able to bring two clients, or $40,000, in additional revenue. This $40,000 is exactly the wage that must be paid that fourth employee. So the consulting firm will break even on the fourth person but will lose money if it hires beyond that. Recall that our first labor market theory assumption is that employers seek to maximize profits. Therefore, the employer will continue to hire until the marginal revenue generated by the last hire is equal to the costs associated with employing that person. Because other potential costs will not change in the short run, the level of demand that maximizes profits is that level at which the marginal revenue of the last hire is equal to the wage rate for that hire. - Exhibit 7.7 shows the connection between the labor market model and the conditions facing a single employer. On the left is the market level supply-and-demand model from Exhibit 7.6, showing that pay level ($40,000) is determined by the interaction of all employers' demands for business graduates. The right side of the exhibit shows supply and demand for an individual employer. At the market-determined rate ($40,000), the individual employer can hire as many business graduates as it wants. Therefore, supply is now an unlimited horizontal line. However, the demand line still slopes downward. The two lines intersect at 4. For this employer, the market-determined wage rate ($40,000) equals the marginal revenue of the fourth hire. The marginal revenue of the fifth graduate is less than $40,000 and so will not add enough revenue to cover costs. The point on the graph at which the incremental income generated by an additional employee equals the wage rate is the marginal revenue product. - A manager using the marginal revenue product model must do only two things: (1) Determine the pay level set by market forces, and (2) determine the marginal revenue generated by each new hire. This will tell the manager how many people to hire. Simple? Of course not. The model provides a valuable analytical framework, but it oversimplifies the real world. In most organizations, it is almost impossible to quantify the goods or services produced by an individual employee, since most production is through joint efforts of employees with a variety of skills. Even in settings that use piece rates (i.e., 50 cents for each soccer ball sewn), it is hard to separate the contributions of labor from those of other resources (efficient machines, sturdy materials, good lighting, and ventilation). So neither the marginal product nor the marginal revenue is directly measurable. However, managers do need some measure that reflects value. In Chapter 5 and Chapter 6, we discussed compensable factors, skill blocks, and competencies. If compensable factors define what organizations value, then job evaluation reflects the job's contribution and may be viewed as a proxy for marginal revenue product. However, compensable factors are usually defined as input (skills required, problem solving required, responsibilities) rather than value of output. This same logic applies to skills and competencies. Labor Supply - Now let us look more closely at the assumptions about the behavior of potential employees. This model assumes that many people are seeking jobs, that they possess accurate information about all job openings, and that no barriers to mobility (discrimination, licensing provisions, or union membership requirements) exist.13 Just as with the analysis of labor demand, these assumptions greatly simplify the real world. As the assumptions change, so does the supply. For example, the upward-sloping supply assumes that as pay increases, more people are willing to take a job. But if unemployment rates are low, offers of higher pay may not increase supply—everyone who wants to work is already working. If competitors quickly match a higher offer, the employer may face a higher pay level but no increase in supply. For example, when Giant Foods raised its hourly pay $1 above the minimum wage in the Chicago area, Wendy's and Burger King quickly followed suit. The result was that the supermarket was paying more for the employees it already had but was still shorthanded. Although some firms find lowering the job requirements and hiring less-skilled workers a better choice than raising wages, this choice incurs increased training costs (which are included in assumption 3).

RELEVANT MARKETS

Economists take "the market" for granted—as in "The market determines wages." But managers at St. Luke's and Apriso realize that defining the relevant markets is a big part of figuring out how and how much to pay. Although the notion of a single homogeneous labor market may be a useful analytical device, each organization operates in many labor markets, each with unique demand and supply. Some, as in the case of hospitals, face segmented supplies for the same skills in the same market. Others, such as Apriso, think more broadly about which markets to use as sources of talent. They seek to answer the question, What is the right pay to get the right people to do the right things? Consequently, managers must define the markets that are relevant for pay purposes and establish the appropriate competitive positions in these markets. The three factors usually used to determine the relevant labor markets are the occupation (skill/knowledge required), geography (willingness to relocate, commute, or become virtual employees), and competitors (other employers in the same product/service and labor markets). Defining the Relevant Market - How do employers choose their relevant markets? Surprisingly little research has been done on this issue. But if the markets are incorrectly defined, the estimates of competitors' pay rates will be incorrect and the pay level and pay mix inappropriately established. - Two studies do shed some light on this issue.42 They conclude that managers look at both competitors—their products, location, and size—and the jobs—the skills and knowledge required and their importance to the organization's success (e.g., lawyers in law firms, software engineers at Microsoft). So depending on its location and size, a company may be deemed a relevant comparison even if it is not a product market competitor. We will see an example in Chapter 8 when we look at how Google and Microsoft define their relevant markets for paying executives. The data from product market competitors (as opposed to labor market competitors) are likely to receive greater weight when: 1. Employee skills are specific to the product market (recall the differences in Boeing millwrights versus GE locomotive millwrights). 2. Labor costs are a large share of total costs. 3. Product demand is responsive to price changes. That is, people won't pay $4 for a bottle of Leinenkugel; instead, they'll go to Trader Joe's for a bottle of Charles Shaw wine, a.k.a. "two-buck Chuck" (the best $2 wine we have ever tasted).43 4. The supply of labor is not responsive to changes in pay (recall the earlier low-wage, low-skill example). e-Compensation - Select several companies that you believe might be labor market competitors (e.g., Microsoft, Oracle, IBM; or Johnson & Johnson, Merck, Pfizer). Compare their job postings on their Web sites. Do any of the companies list salaries for their jobs? Do they quote a single salary? Do they allow room for haggling? Globalization of Relevant Labor Markets: Offshoring and Outsourcing - We will discuss globalization and international issues more fully in Chapter 16. For now, we note that work flowing to lower wage locations is not new. Historically, clothing (needle trades) and furniture jobs flowed from New England to southern states. Nor is work flowing across national borders new. First, it was low-skill and low-wage jobs (clothing and Mardi Gras beads) from the U.S. to China and Central America; then higher-paid blue collar jobs (electronics, appliances); now it is service and professional jobs (accounting, legal, engineering, radiology). Vastly improved communication and software connectivity have accelerated these trends. For example, programming code and radiographic images can now be transported in an instant across the world. In Chapter 4, we discussed characteristics of jobs (e.g., easily routinized, inputs/outputs easily transmitted electronically, little need for interaction with other workers, little need for local knowledge such as unique social and cultural factors) that are thought to increase susceptibility to offshoring (i.e., moving jobs to other countries). Here, we discuss why firms use offshoring, as well as challenges in doing so. Several years ago, IBM found that a computer programmer (one of the occupations reported in Chapter 4 to be most susceptible to offshoring) in the United States with three to five years of experience cost $56 per hour in total compensation. In China, a similarly qualified programmer cost $12.50 per hour.44 Based on these data, IBM estimated that it could save $168 million per year by shifting some of these programmer jobs to countries like China, India, and Brazil. That sort of savings is difficult to ignore, especially when competing firms are either based in lower labor cost countries (e.g., Infosys in India) or are offshoring or expanding operations there. As noted, offshoring is also happening to lawyers and financial services jobs. In Mumbai, India, Pangea3 LLC employs Indian lawyers to do legal work for Wall Street banks. Whereas starting associates in the United States might bill more than $200 per hour, similar lawyers in India might bill something closer to $75 to $100 per hour.45 In financial services, Copal Partners of India has seen large increases in its business as Wall Street firms not only outsource or offshore "back office" work (e.g., processing of transactions), but increasingly also production of research reports, trading recommendations, and so forth. Citigroup now employs over 20,000 people in India and Deutsche Bank has about 6,000. According to one observer, "There's a huge amount of grunt work that has been done by $250,000-a-year Wharton M.B.A.s" but "some of that stuff, it's natural to outsource it."46 It is possible that more sophisticated jobs will increasingly follow. While large differences in labor costs cannot simply be ignored, there are other factors to consider in deciding where jobs will be.47 First, as we saw in Chapter 1 and as we will see in more detail in Chapter 16, countries with lower average labor costs also tend to have lower average productivity. So, a company must assure itself that labor costs savings, such as those available in China (relative to the United States), will not be neutralized by the offshore country's lower productivity. One determinant of productivity is the skill level of the workforce. According to the Global Competitiveness Report, China ranks 44th of 140 countries in terms of "ease of finding skilled employees," whereas the United States ranks 1st. There may also be other risks. Again, in the case of China, intellectual property protection continues to be a concern. The Global Competitiveness Report ranks China 49th on intellectual property protection, compared to a rank of 13th for the United States. (Finland is ranked 1st).48 Second, agency theory, which we discuss later, tells us that companies must devote resources to systems that monitor worker effort or output. This, as well as coordination of efforts, can be more difficult and more costly when geographic or cultural distance is great (and time zones different), even with advances in technology.49 Third, customers' reactions must be considered. For example, Delta Air Lines Inc. decided to stop using call centers in India to handle sales and reservations, despite the fact that call-center workers in India earn roughly $500 a month (about one-sixth of U.S.-based call-center workers). Delta said that customers had trouble communicating with India-based representatives. Delta's CEO explained that "customer acceptance of call centers in foreign countries is low," adding, "Our customers are not shy about letting us have that feedback."50 Fourth, if labor costs are the driving force behind placing jobs, one must ask how long the labor cost advantage at a significantly lower wage will hold up, and whether sufficiently qualified employees will continue to be available as other companies also tap into this pool of labor. However, nothing is forever, and labor cost savings from offshoring and/or outsourcing can, of course, have a substantial effect on profits for many years before the cost advantage becomes small enough to be offset by other factors. We return to this issue in Chapter 16. A compelling example is Apple's manufacturing strategy for its iPad and iPhone. The labor cost savings that Apple realizes by outsourcing assembly of these products to Foxconn is many billions of dollars compared to what it would cost to do assembly in the United States. Exhibit 7.11 shows that under Scenario 1, assembly of the iPhone and iPad in the United States would decrease operating income by $8.0 billion (24 percent). Under Scenario 2, operating income would be decreased by $14.8 billion (44 percent). Thus, if these products were assembled in the States, Apple would need to either (a) tell shareholders that profits (and thus shareholder return) will be reduced by billions of dollars, or (b) pass along the increased cost to the consumer, which, unless demand is inelastic (unlikely) would result in lower sales and thus, once again, lower profits and shareholder return.

COMPENSATION STRATEGY: EXTERNAL COMPETITIVENESS

In Part Two, Internal Alignment, we looked at comparisons inside the organization. In external competitiveness, our second pay policy, we look at comparisons outside the organization—comparisons with other employers that hire people with the same skills. A major strategic decision is whether to mirror what competitors are paying or to design a pay package that may differ from those of competitors but better fits the business strategy. External competitiveness is expressed in practice by (1) setting a pay level that is above, below, or equal to that of competitors; and (2) determining the pay mix relative to those of competitors. External competitiveness refers to the pay relationships among organizations—the organization's pay relative to its competitors. Pay level refers to the average of the array of rates paid by an employer: (base + bonuses + benefits + value of stock holdings) / number of employees Pay mix refers to the various types of payments, or pay forms, that make up total compensation. Both pay-level and pay-mix decisions focus on two objectives: (1) control costs and increase revenues and (2) attract and retain employees. Control Costs and Increase Revenues - Pay-level decisions have a significant impact on expenses. Other things being equal, the higher the pay level, the higher the labor costs: Labor costs = (pay level) times (number of employees) - Furthermore, the higher the pay level relative to what competitors pay, the greater the relative costs to provide similar products or services. So you might think that all organizations would pay the same job the same rate. However, as we saw in the opening to Part Three, they do not. Why would Google pay more than IBM for software engineers? What would any company pay above whatever minimum amount is required to hire engineers or other employees? Paying employees above market can be an effective or ineffective strategy. It all depends on what the organization gets in return and whether that return translates into revenues that exceed the cost of the strategy. Let's look at a few examples. Exhibit 7.1 compares labor costs at the U.S. Big Three automakers with those at two Japanese automakers (Toyota, Honda) in the United States. It also compares what the companies get in return. As of 2007, U.S. automakers had higher labor costs, but lower reliability and lower road-test performance ratings, on average. GM and Chrysler (now Fiat Chrysler Auto, stock ticker FCAU) subsequently went through bankruptcy. One might infer that the Big Three's pay-level strategy has not worked for it. (In Chapter 1, we also noted the huge drop in employment among U.S. producers like GM.) As part of that process and also as a result of government involvement, agreements were reached with the United Auto Workers to reduce labor costs to make them competitive with Japanese producers. Indeed, there was no increase in hourly wage between 2007 and 2015. The Big Three have long preferred profit sharing to increasing their fixed labor costs. As Exhibit 7.1 indicates, as of 2018/2019, labor costs for Ford, GM, and Chrysler were significantly lower than previously. - In 2015 the UAW reached similar agreements with General Motors, Ford, and Fiat Chrysler that included, for Tier 1 workers, 3 percent salary increases in years 1 and 3 and lump-sum payments (i.e., salaries would not increase) of 4 percent in years 2 and 4 of the contract. Tier 2 workers received larger salary increases to greatly narrow the pay differential with Tier 1 workers, but over the course of a number of years. (See Exhibit 7.1.) Profit sharing and other bonus plans, which help control fixed labor costs, play at least as large a role compared to past contracts. (See also the end of chapter Your Turn: Two-Tier Wages.) - The harder question to answer is whether the quality and performance of the cars will also become more competitive. Actually, according to Exhibit 7.1, the Big Three have made major strides. However, when looking at the entire picture of road-test performance, reliability/dependability (from Consumer Reports and J.D. Power), in combination with labor costs, the Big Three still have some way to go to match Toyota and Honda. In a global competitive market, automakers have a choice as to where to locate production to best achieve cost, productivity, and quality goals.6 Consider the locations of new automobile plants in North America since 2005. In the United States, the last announced new plant was 2008 (opened in 2011) by Volkswagen in Chattanooga, Tennesee. Prior to that, since 2005, three other plants have opened in the United States, all in the South (Alabama, Mississippi, Georgia), all non-union. In contrast, since 2005, seven new plants in Mexico have been opened or announced, with six of those being since 2011, the year of the last new U.S. plant. Labor costs are lower in Mexico than in the United States (Volkswagen estimates they are 50 percent lower than in Tennessee, which are already lower than in the northern states and lower than in Germany, where Volkswagen is headquartered). Mexico also has free-trade agreements that give it duty-free access to markets that represent about 60 percent of the world's economic output. Automakers seem to feel they are able to also achieve vehicle production efficiency and quality goals as well, something to which they devote much effort.7 Exhibit 7.2 traces the history of two "legacy" airlines, USAir and American, and relative newcomer, Southwest. As in the automobile industry, we can look at what employees cost and what the airlines receive in return that would help drive revenues. American was the last major airline to go through bankruptcy, entering in 2011 and exiting in late 2013, which included a proposed merger (subsequently executed) with USAir. Note that by 2014 the new combined company actually had lower labor costs and lower operating costs per available seat mile (ASM) than Southwest. However, with consolidation and a healthier profit outlook for the airline industry overall, American (and others) have faced increasing pressures from employees to increase wages and salaries and thus labor costs. In 2000, USAir and American trailed Southwest in terms of efficiency, with overall operating costs of 14 cents per ASM, almost double that of Southwest at 7.7 cents per ASM. Likewise, USAir had labor costs per ASM roughly double (5.5 cents versus 2.8 cents) that of Southwest Airlines. American, while not having labor costs as high as those of USAir, still had a significantly higher cost structure than Southwest. USAir and other so-called legacy airlines realized that they needed to move their costs lower to compete with Southwest. (Question: What would labor costs and operating income be at American and USAir in 2000 if their labor cost/ASM had been the same as Southwest's?) By 2008 (not shown), both USAir and American had made considerable progress, at least with respect to labor costs, basically drawing even with Southwest on labor cost per ASM. By 2014 the new merged company had lower labor costs than Southwest (though only Southwest had positive operating income). Part of USAir's success in reducing labor costs was due to its having gone through bankruptcy in 2002 (the first major airline to do so, subsequently followed by all others) and using that as an opportunity to reduce pay and benefits costs. However, American (including the former USAir) remains at a disadvantage with respect to the passenger experience. In all years, at least until recently (e.g., see 2017), Southwest has had many fewer customer complaints and higher customer satisfaction. If anything, Southwest's advantage in customer satisfaction seemed to have increased between 2000 and 2014 as USAir and American cut costs. By 2017, however, Southwest's advantage on the customer experience had narrowed considerably. Even though Southwest continued to improve, American improved much more. As such, although Southwest may continue to be a somewhat better bet going forward due to its continued advantage in terms of the customer experience, that advantage of late has eroded. It will be interesting to see if American can continue to improve on this metric. In any case, the history of Southwest suggests that it is not necessarily how much it pays that is the key. Rather, it can be argued that it is its ability to pay competitively and get a great deal in return from its employees. Southwest has been widely studied for its total compensation strategy, which includes employee profit sharing and stock, but also having fun at work and strong employee relations. Southwest is unique in the airline industry both for its 45 consecutive years of profitability (compare, for example, USAir's consecutive years of losses, from 1989 to 1999) and as the lone major airline not to go through bankruptcy. However, there is growing concern that Southwest's labor costs are or may become a problem. It will be interesting to see what the future brings in the airline industry for companies using different compensation and human resource approaches. Attract and Retain the Right Employees - One company may pay more because it believes its higher-paid engineers are more productive than those at other companies. Their engineers may be better trained; maybe they are more innovative in dreaming up new applications. Maybe they are less likely to quit, thus saving the company recruiting and training costs. Another company may pay less because it is differentiating itself on nonfinancial returns—more challenging and interesting projects, possibility of international assignments, superior training, more rapid promotions, or even greater job security. Different employers set different pay levels; that is, they deliberately choose to pay above or below what others are paying for the same work. That is why there is no single "going rate" in the labor market for a specific job.8 Not only do the rates paid for similar jobs vary among employers, but a single company may set a different pay level for different job families.9 The company in Exhibit 7.3 illustrates the point. The top chart shows that this particular company pays about 2 percent above the market for its entry-level engineer. (Market is set at zero in the exhibit.) However, it pays 13 percent above the market for most of its marketing jobs and over 25 percent above the market for marketing managers. Office personnel and technicians are paid below the market. So this company uses very different pay levels for different job families. - These data are based on comparisons of base wage. When we look at total compensation in the bottom of the exhibit, a different pattern emerges. The company still has a different pay level for different job families. But when bonuses, stock options, and benefits are included, only marketing managers remain above the market. Every other job family is now substantially below the market. Engineering managers take the deepest plunge, from only 2 percent below the market to over 30 percent below.10 - The exhibit, based on actual company data, makes two points. First, companies often set different pay-level policies for different job families. Second, how a company compares to the market depends on what competitors it compares to and what pay forms are included. It is not clear whether the company in the exhibit deliberately chose to emphasize marketing managers and de-emphasize engineering in its pay plan or if it is paying the price for not hiring one of you readers to design its plan.11 Either way, the point is, people love to talk about "the market rate" as if a single rate exists for any job, with the implication that organizations are constrained to pay that same rate to their own employees in that job. Nevertheless, Exhibit 7.4 instead shows that organizations can and do vary in how closely they match the "going rate." There is no single "going mix" of pay forms, either. Exhibit 7.4 compares the pay mix for the same job (software marketing manager) at two companies in the same geographic area. Both companies offer about the same total compensation. Yet the percentages allocated to base, bonuses, benefits, and options are very different.

MODIFICATIONS TO THE DEMAND SIDE

The story is told of the economics professor and the student who were strolling through campus together. "Look," the student cried, "there's a $100 bill on the path!" "No, that cannot be," the wiser head replied. "If there were a $100 bill, someone would have picked it up." The point of the story is that economic theories must frequently be revised to account for reality. When we change our focus from all the employers in an economy to a particular employer, models must be modified to help us understand what actually occurs. A particularly troublesome issue for economists is why an employer would pay more than what theory states is the market-determined rate. Exhibit 7.8 looks at three modifications to the model that address this phenomenon: compensating differentials, efficiency wage, and signaling. Compensating Differentials - More than 200 years ago, Adam Smith argued that individuals consider the "whole of the advantages and disadvantages of different employments" and make decisions based on the alternative with the greatest "net advantage."14 If a job has negative characteristics—for example, if the necessary training is very expensive (medical school), job security is tenuous (stockbrokers, CEOs), working conditions are disagreeable (highway construction), or chances of success are low (professional sports)—then employers must offer higher wages to compensate for these negative features. Such compensating differentials explain the presence of various pay rates in the market. Although the notion is appealing, it is hard to document, due to the difficulties in measuring and controlling all the factors that go into a net-advantage calculation. Efficiency Wage - According to efficiency wage theory, high wages may increase efficiency and actually lower labor costs if they: 1. Attract higher-quality applicants. 2. Lower turnover. 3. Increase worker effort. 4. Reduce shirking behavior (the term economists use to mean "screwing around"). The higher the wage, the less likely it is that an employee would be able to find another job that pays as well. Also, the risk of losing one's high-paying job depends on how likely it is that the employee can be replaced. One indicator is the unemployment rate. (Karl Marx referred to the unemployed as a "reserve army" that employers can use to replace current workers.) Thus, efficiency wage predicts that high effort will be most likely, and shirking less likely, to the degree that the wage premium is high and the unemployment rate is high. 5. Reduce the need to supervise employees (academics say "monitoring"). - So, basically, efficiency increases by hiring better employees or motivating present employees to work smarter or harder. The underlying assumption is that pay level determines effort—again, an appealing notion that is difficult to document. In Appendix 7-A, we show how utility theory can help compare the costs and benefits of different pay-level policies. We will also discuss how business strategy plays a role in pay-level choice. There is some research on efficiency wage theory, however.15 One study looked at shirking behavior by examining employee discipline and wages in several auto plants. Higher wages were associated with lower shirking, measured as the number of disciplinary layoffs. However, the authors of the study were unable to say whether shirking was reduced enough to offset (cover) the costs of the higher wage.16 Research shows that higher wages actually do attract more qualified applicants.17 But higher wages also attract more unqualified applicants. Few companies evaluate their recruiting programs well enough to show whether they do in fact choose only superior applicants from the larger pool. So an above-market wage does not guarantee a more productive workforce. Does an above-market wage allow an organization to operate with fewer supervisors? Some research evidence says yes. A study of hospitals found that those that paid high wages to staff nurses employed fewer nurse supervisors.18 The researchers did not speculate on whether the higher wages attracted better nurses or caused average nurses to work harder. They also did not say whether the hospital was able to reduce its overall nursing costs. An organization's ability to pay is related to the efficiency wage model. Firms with higher profits than competitors are able to share this success with employees. This could be done via "leading" competitors' pay levels and/or via bonuses that vary with profitability. Academics see this as "rent sharing." Rent is a return (profits) received from activities that are in excess of the minimum (pay level) needed to attract people to those activities.19 Pay levels at more profitable firms were about 15 percent greater than at firms with lower profits, according to one study.20 Notice that the discussion so far has dealt with pay level only. What forms to pay—the mix question—is virtually ignored in these theories. The simplifying assumption is that the pay level includes the value of different forms. Abstracted away is the distinct possibility that some people find more performance-based bonus pay or better health insurance more attractive. Signaling theory is more useful in understanding pay mix. Sorting and Signaling - Sorting, introduced in Chapter 1, is the effect that pay strategy has on the composition of the workforce—who is attracted and who is retained. Signaling is a closely related process that underlies the sorting effect. Signaling theory holds that employers deliberately design pay levels and pay mix as part of a strategy that signals to both prospective and current employees the kinds of behaviors that are sought.21 Viewed through a marketing lens, how much to pay and what forms of pay are offered establishes a "brand" that sends a message to prospective employees, just like brands of competing products and services.22 A policy of paying below the market for base pay yet offering generous bonuses or training opportunities sends a different signal, and presumably attracts different people, than does a policy of matching the market wage and offering no performance-based pay. An employer that combines lower base pay with high bonuses may be signaling that it wants employees who are risk takers. Its pay policy helps communicate expectations. Check out Exhibit 7.4 again. It shows a breakdown of forms of pay for two competitors, as well as their relationship to the market. The pay mix at company A emphasizes base pay (84 percent) more than does the mix at company B (64 percent) or the market average (67 percent). Company A pays no bonuses, no stock options, and somewhat lighter benefits. Company B's mix is closer to the market average. What is the message that A's pay mix is communicating? Which message appeals to you, A's or B's? The astute reader will note that at A, you can earn the $112,349 with very little apparent link to performance. Maybe just showing up is enough. At B, earning the $112,748 requires performance bonuses and stock options as well. Riskier? Why would anyone work at B without extra returns for the riskier pay? Without a premium, how will B attract and retain employees? Perhaps with more interesting projects, flexible schedules, or more opportunity for promotions—all part of B's "total pay brand." A study of college students approaching graduation found that both pay level and pay mix affected their job decisions.23 Students wanted jobs that offered high pay, but they also showed a preference for individual-based (rather than team-based) pay, fixed (rather than variable) pay, job-based (rather than skill-based) pay, and flexible benefits. Job seekers were rated on various personal dimensions—materialism, confidence in their abilities, and risk aversion—that were related to pay preferences. Pay level was most important to materialists and less important to those who were risk-averse. So applicants appear to select among job opportunities based on the perceived match between their personal dispositions and the nature of the organization, as signaled by the pay system. Both pay level and pay mix send a signal, which results in sorting effects (i.e., who joins and who stays with the organization). Signaling works on the supply side of the model, too, as suppliers of labor signal to potential employers. People who are better trained, have higher grades in relevant courses, and/or have related work experience signal to prospective employers that they are likely to be better performers. (Presumably they signal with the same degree of accuracy as employers.) So both characteristics of the applicants (degrees, grades, experience) and organization decisions about pay level (lead, match, lag) and mix (higher bonuses, benefit choices) act as signals that help communicate.

PRODUCT MARKET FACTORS AND ABILITY TO PAY

The supply and demand for labor are major determinants of an employer's pay level. However, any organization must, over time, generate enough revenue to cover expenses, including compensation. It follows that an employer's pay level is constrained by its ability to compete in the product/service market. So product market conditions to a large extent determine what the organization can afford to pay. Product demand and the degree of competition are the two key product market factors. Both affect the ability of the organization to change what it charges for its products and services. If prices cannot be changed without decreasing sales, then the ability of the employer to set a higher pay level is constrained. Product Demand - Although labor market conditions (and legal requirements) put a floor on the pay level required to attract sufficient employees, the product market puts a lid on the maximum pay level that an employer can set. If the employer pays above the maximum, it must either pass on to consumers the higher pay level through price increases or hold prices fixed and allocate a greater share of total revenues to cover labor costs. Degree of Competition - Employers in highly competitive markets, such as manufacturers of automobiles or generic drugs, are less able to raise prices without loss of revenues. At the other extreme, single sellers of a Lamborghini or a breakthrough cancer treatment are able to set whatever price they choose. However, too high a price often invites the eye of government regulators. Other factors besides product market conditions affect pay level. Some of these have already been discussed. The productivity of labor, the technology employed, the level of production relative to plant capacity available—all affect compensation decisions. These factors vary more across than within industries. The technologies employed and consumer preferences may vary among auto manufacturers, but the differences are relatively small compared to the differences between the technology and product demand of auto manufacturers versus those of the oil or financial industry. A Different View: What Managers Say - Discussions with managers provide insight into how all of these economic factors translate into actual pay decisions. In one study, a number of scenarios were presented in which unemployment, profitability, and labor market conditions varied.27 Managers were asked to make wage adjustment recommendations for several positions. Level of unemployment made almost no difference. One manager was incredulous at the suggestion that high unemployment should lead to cutting salaries: "You mean take advantage of the fact that there are a lot of people out of work?" The company's profitability was considered a factor for higher management in setting the overall pay budget but not something managers consider for individual pay adjustments. What it boiled down to was "whatever the chief financial officer says we can afford!" They thought it shortsighted to pay less, even though market conditions would have permitted lower pay. In direct contradiction to efficiency-wage theory, managers believed that problems attracting and keeping people were the result of poor management rather than inadequate compensation. They offered the opinion that "supervisors try to solve with money their difficulties with managing people."28 Of course, what managers say that they would do in a hypothetical situation is not necessarily what they would do when they actually experience a situation. Nor are their views or decisions necessarily the same as those of managers in other companies that do things differently. In this same vein, what managers think is not always what their employees think. In 2009-2011 when the unemployment rate was higher than it had been in two decades, companies did indeed make pay cuts, either outright or by requiring employees to take days off (often called furloughs) without pay. Another common cut was reducing contributions to 401k retirement plans. Other companies imposed pay freezes.29 Such cuts are hard to find now that the unemployment rate is at its lowest level in decades, making attraction and retention priority one. With respect to differences in manager/employer and employee views, consider employee retention. A national survey found that pay was the most often cited reason (51 percent) among high-performing employees for leaving, whereas relationship with supervisor was cited only 1 percent of the time by such employees. Employers, however, somewhat underestimated the role of pay (with 45 percent citing its role versus 51 percent of employees) and they very much overestimated the role of relationship with supervisor (with 31 percent citing its role versus 1 percent of employees).30 Segmented Supplies of Labor and (Different) Going Rates - However, faced with significant competition, a number of employers have cut pay. As we saw earlier, the U.S. airline industry is a notable example. Significant differences in wages paid around the world and the ease of offshoring work have also led many companies to consider this action.31 Other options to reduce labor costs include segmenting the source of labor. - People Flow to the Work= Consider how a hospital staffs and pays its nursing positions and what each method costs. The number of nurses the hospital needs on each shift depends on the number of patients. To deal with fluctuating patient numbers, the hospital uses four different sources of nurses, as shown in Exhibit 7.10. The segmented supply results in nurses working the same jobs side by side on the same shift, but earning significantly different pay and/or benefits and having different relationships with the hospital and the other nurses and health care professionals. This is a case of people flowing to the work. The hospital cannot send its nursing work to other cities or other nations. - Work Flows to the People—On-Site, Off-Site, Offshore= Apriso, a Long Beach, California, company, designs and installs computer-assisted manufacturing software that is used in factories around the world. When Apriso competes for a project, the bid is structured in part on the compensation paid to people in different locations. Apriso can staff the project with employees who are on-site (in Long Beach), off-site (contract employees from throughout the United States), or offshore. Design engineers in Long Beach earn about twice as much as those in Krakow, Poland. Apriso can "mix and match" its people from different sources. Which source Apriso includes in its bid depends on many factors: customer preferences, time schedules, the nature of the project. To put together its bids, Apriso managers need to know pay levels and the mix of forms of pay, not only in the market in Long Beach but also in other locations, including Krakow, Shanghai, Vancouver, and Bangalore. (We return to this topic later in this chapter.) There are three points ("so whats?") to take with you from this discussion: 1. Reality is complex and theories are abstract. It is not that our theories are useless. They simply abstract away the detail, clarifying the underlying factors that help us understand how reality works. Theories of market dynamics, the interaction of supply and demand, form a useful foundation. 2. The segmented sources of labor means that determining pay levels and pay mix increasingly requires understanding market conditions in different, even worldwide, locations. 3. Managers also need to know the jobs required to do the work, the tasks to be performed, and the knowledge and behaviors required to perform them (sound like job analysis?) so that they can bundle the various tasks to send to different locations.

MODIFICATIONS TO THE SUPPLY SIDE (ONLY TWO MORE THEORIES TO GO)

Two theories shown in Exhibit 7.9—reservation wage and human capital—focus on understanding employee behavior: the supply side of the model. Reservation Wage - At times, it seems that economists must have quite a sense of humor. How else do we explain why they would choose to describe pay using the term "noncompensatory"? What they mean is that job seekers have a reservation wage level below which they will not accept a job offer, no matter how attractive the other job attributes. If pay level does not meet their minimum standard, no other job attributes can make up (i.e., compensate) for this inadequacy. Other theorists go a step further and say that some job seekers—satisfiers—take the first job offer they get where the pay meets their reservation wage. A reservation wage may be above or below the market wage. The theory seeks to explain differences in workers' responses to offers. Reservation levels likely exist for pay forms, too, particularly for health insurance. A young high school graduate recently told us, "If I can't find a job that includes health insurance, I will probably go to college." Human Capital - The theory of human capital, perhaps the most influential economic theory for explaining pay-level differences, is based on the premise that higher earnings flow to those who improve their potential productivity by investing in themselves (through additional education, training, and experience).24 The theory assumes that people are in fact paid at the value of their marginal product. Improving productive abilities by investing in training or even in one's physical health will increase one's marginal product. In general, the value of an individual's skills and abilities is a function of the time, expense, and effort to acquire them. Consequently, jobs that require long and expensive training (engineering, physicians) should receive higher pay than jobs that require less investment (clerical work, elementary school teaching).25 As pay level increases, the number of people willing to make that investment increases, thereby creating an upward-sloping supply. In fact, different types of education do get different levels of pay. In the United Kingdom, new graduates with a degree in math, law, or economics will earn around 25 percent more than job seekers their age who do not have a college degree. An extra year of education adds about $4,200 per year. A number of additional factors affect the supply of labor.26 Geographic barriers to mobility among jobs, union requirements, lack of information about job openings, the degree of risk involved, and the degree of unemployment also influence labor markets. Also, nonmonetary aspects of jobs (e.g., time flexibility) may be important aspects of the return on investment.

WHAT SHAPES EXTERNAL COMPETITIVENESS?

Exhibit 7.5 shows the factors that affect decisions on pay level and pay mix. The factors include (1) competition in the labor market for people with various skills; (2) competition in the product and service markets, which affects the financial condition of the organization; and (3) characteristics unique to each organization and its employees, such as its business strategy, technology, and the productivity and experience of its workforce. These factors act in concert to influence pay-level and pay-mix decisions.

January is always a good month for travel agents in Ithaca, New York. In addition to the permanent population eager to flee Ithaca's leaden skies, graduating students from Ithaca's two colleges are traveling to job interviews with employers across the country—at company expense, full fare, no Saturday-night stayovers required. When they return from these trips, students compare notes and find that even for people

receiving the same degree in the same field from the same college, the offers vary from company to company. What explains the differences? Location has an effect: Firms in San Francisco and New York City make higher offers. The kind of work also has an effect: In HR, for example, jobs in employment pay a little less than jobs in compensation. (Now aren't you glad you didn't drop this course?) And the industry to which the different firms belong has an effect: Pharmaceuticals, brokerage houses, and petroleum firms tend to offer more than consumer products, insurance, and heavy-manufacturing firms.3 Students would like to attribute these differences to themselves: differences in grades, courses taken, interviewing skills, and so on. But the same company makes the identical offer to most of its candidates at the school. So it is hard to make the case that an individual's qualifications totally explain the offers. Why would companies extend identical offers to most candidates? And why would different companies extend different offers? This chapter discusses these choices and what difference they make for the organization. Pay levels at firms are not completely static. They also can adjust over time to changing market conditions and/or business strategies. The unemployment rate has dropped significantly in recent years, making for increased competition among retailers to hire and retain hourly workers. As a result, Amazon, Gap, Walmart, and Target all raised their lowest wage rate recently.4 Health insurance company Aetna, Inc. also announced a plan to increase pay at its lowest levels, by as much as one-third for some of those workers. A Deutsche Bank economist explained this increase as being due to the tightening of the labor market: "We are getting to the stage where companies can no longer find the right workers." However, Aetna's chief executive officer also cited a strategic rationale: "We're preparing our company for a future where we're going to have a much more consumer-oriented business" and for that reason Aetna wants to have "a better and more informed work force."5 The sheer number of economic theories related to compensation can make this chapter heavy going. Another difficulty is that the reality of pay decisions doesn't necessarily match the theories. The key to this chapter is to always ask: So what? How will this information help me?