Effectiveness of Pay for Performance

Question: Discuss about the Effectiveness of Pay for Performance. Answer: Introduction For workers globally, a high pay acts a motivating instrument for better work performance and enhanced productivity. In labor economics, the efficiency wage hypothesis highlights the fundamental relationship between workers performance and their pay. By and large, it elucidates that paying workers beyond the market clearing rate helps to increase employee productivity and boost their morale. Furthermore, the model suggests that organizations should offer their workers higher wages than the equilibrium wage to enhance workplace cohesiveness, reduce shirking, and increase employee responsibility and loyalty to the firm. In contrast, paying wages below the market rate will result in employee dissatisfaction, increase shirking and escalate the turnover rate. Overall, the theory suggests that offering employees higher wages than the market rate is beneficial to both the firm and the worker. Notably, paying wages and salaries is one of the major costs of running a company. Normally, in a competitive labor market, the remunerations of the employees are dictated by the forces of demand and supply[1]. Thus, such markets offer its workforce an equilibrium wage. However, this phenomenon is not usually existent and applicable in the modern economy. Instead, the actual amounts that employers pay its employees vary significantly from one firm to another. For this reason, the efficiency wages theory provides an illumination to the fact that it might be beneficial for firms to pay its workers more than the equilibrium wage. More specifically, if the business pays its workers a high wage, they work harder and produce more output than if they are paid the market rate. Therefore, according to this hypothesis, there is a positive relationship between worker productivity and pay. The Concept of Pay for Performance To a large extent, the theory of efficiency wages serves as a justification as to why certain organizations prefer to pay workers more than prevailing market rate. Profoundly, paying employees a pay premium boosts their efficiency, increases workplace unity, enhances loyalty and moderates shirking[2]. Conversely, low wages contribute substantially to reduced productivity and worker dissatisfaction which may then give rise to shirking, disruption as well as high turnover rates[3]. In this regard, there are various efficiency wage models that help illustrate the relationship between pay and performance. Currently, the most prominent models include the shirking model, labor turnover model, the adverse selection model and the sociological hypothesis. The Shirking Model In most occupations, the labor force has some discretions regarding its performance. Mainly, these discretions arise from the fact that work contracts cannot explicitly specify all characteristics of an employees performance[4]. For this reason, piece rates become unrealistic because monitoring may be too expensive or imprecise. Furthermore, they may not be viable since the basis on which they are founded are not verifiable by employees, thus generating the problem of moral hazard. Consequently, in this case, the payment of a wage that is above the equilibrium wage acts as a way for businesses to offer its workers motivation to work. According to Cheat-threat theory,' employees can choose to work or not to work. However, employees who do not work run the risk of getting caught, which may, in turn, lead to loss of their jobs[5]. Hence, if there is a risk associated with shirking, the fear of being caught and fired motivates the employees not to shirk. Instead, they would remain diligent in their work. Conversely, if all firms paid the same wages to its workers, and the labor market operates at full employment, then there would be no cost associated with shirking[6]. In turn, this would create an incentive for workers to shun their duties. For this reason, it is beneficial for the firm to raise its wages over and above the market clearing rate as it eliminates shirking. When all companies do this, then the level of wages rises while the unemployment increases. Notably, firms prefer to hire workers at wages above the market price. If the organization were to employ personnel at lower wages, it would be beneficial for the employee to abscond his duties. Given that the firm is aware of this, it maintains a relatively high wage portfolio for its workers to avoid discretions on the employees part[7]. Since all firms raise their salaries to prevent shirking, involuntary unemployment may arise. Subsequently, the prevalence of high unemployment in the market increases the opportunity cost associated with shirking. More precisely, it creates a small or no alternative income for the unemployed, which makes losing ones job more costly. In turn, this serves as an instrument that disciplines workers against shirking. Critics of the model argue that moral hazards may shift to employers. Fundamentally, organizations are responsible for monitoring employees efforts. Thus, unambiguous incentives may arise for organizations to proclaim shirking even when the workers work diligently. Typically, firms may have reasons to fire older employees and replace them with more energetic younger workers. Particularly, one can attribute this to the fact that older workers are often paid above their marginal productivity level, thus creating substantial costs for the firm. As a result, this may create credibility problems in the firm. However, the gravity of this issue largely depends on the degree to which external auditors can evaluate employees efforts. This way, companies may reduce their cheating and declare shirking among its workers only when it is true. Labour Turnover Model Aside from reducing shirking, the firm may also offer above average wages to reduce the costs of labor turnover. Prominently, the formal structure of the two models is almost similar. More specifically, workers will be more keen on maintaining their current employment if it offers a high wage above the average wage rate[8]. Also, they would be discouraged from quitting their employment if the economy depicts a high aggregate unemployment rate. Thus, if all firms offer an equal pay above the equilibrium rate, then there would be a high rate of involuntary unemployment. Consequently, this would serve as a deterrence for a high turnover since employees would prefer to maintain their current wages than becoming unemployed. Contrary to this view, Salop provides an alternative solution for the involuntary unemployment. More precisely, he argues that more sophisticated job contracts may offer Pareto-superior solutions to the problem[9]. Instead of paying both new and old workers an identical wage, the firm may differentiate their salaries. Thus, the new employees should be offered a pay equal to the disparity between training costs their marginal product. Specifically, a seniority salary system may help achieve this. Unlike in the shirking model, a training or employment fee may be initiated to reduce the risk of a moral hazard[10]. According to this model, it is not in the interest of the firm to dismiss its trained workers, as it would be disadvantageous. As such, training costs are expensive for the firm, and thus, try to avoid them as much as possible. The business may also draw explicit term contracts with the employee to insure themselves against high labor turnover. Besides, the great pay and salar ies offered by the firm act as a perfect deterrent to turnover as workers who to remain in employment than become unemployed. Adverse Selection Model Remarkably, this model further builds on the concept of pay for performance by highlighting the relationship between wages and employee productivity. Performance highly depends on workers abilities and the labor force has a heterogeneous ability. Notably, the workers reservation wage and their ability are positively correlated. Thus, firms offer high pay attract skilled applicants. Mainly, this model assumes that each firm compensates its workers with an efficiency wage. For this reason, the employer rejects persons who offer their expertise for below average wages. Predominantly, one can attribute this to the fact that employees who offer their services and expertise below the market clearing wage have doubt in their ability to perform productively, thereby raising the firms suspicion that they are unproductive. Primarily, this model provides that wage rigidity may be as a result of social principles and conventions of proper actions that are not typically individualistic. More profoundly, employees effort relies on their work standards[11]. Likewise, the partial gift exchange model suggests that the business can be successful in enhancing the average work effort and elevate group work norms by offering its employees a gift. In this case, the gift is a salary above the equilibrium wage rate to award employees for their effort above the minimum expectation. Predominantly, this hypothesis applies to public sector workers and firms. According to economic literature, monetary incentives may crowd in workers enthusiasm when they view the rewards as an acknowledgment of their high productivity and effort[12]. This way, both the employer and employee benefit from higher wages. Characteristically, the worker thrives on the feeling of acknowledgment and appreciation while the firm benefits from a hig her level of worker productivity. Application of Efficiency Wages in Real life For a long time now, economic models and theories have been implemented in the real world to achieve desired objectives for the firm and the economy as a whole. In the same way, the efficiency wage hypothesis is applied in various enterprises and sectors of the economy to achieve improved productivity, enhance labor force morale and reduce turnovers[13]. One famous example of the application of the theory of efficiency wages is Henry Fords US$5-a-day wage[14]. Notably, Ford Motors utilized the model to reduce the high turnover ratio that the company was experiencing. Often, working in the assembly sector is tedious and repetitive, thus unattractive for many workers. As a result, the firm was spending a lot of money in training new workers now and then[15]. New workers were also slow and less productive compared to old workers. Indeed, this was too expensive for Ford Motors. Eventually, the firm introduced an efficiency wage to reduce the high turnover and ultimately drive down costs associated with training new workers. Hence, it compensated its employees with a pay above the market-clearing rate for their skill level. Sequentially, this brought about significant benefits for the company[16]. First, the company achieved a lower turnover of its workers. What is more, the workers exhibited better performance of their duties which significantly improved their productivity. Eventually, the firm achieved high productivity alongside reduced training costs following the reduction of the turnover rate of its labor force. Conclusion Normally, in the contemporary business world, firms seek to maximize their profitability by minimizing costs and maximizing productivity. Essentially, the efficiency wage theory provides a foundation for businesses to achieve this goal[17]. As a whole, the hypothesis depicts the effectiveness of pay for performance incentives and highlights how incentive compensation is essential to business. In addition, it outlines the various benefits associated with paying workers an efficiency wage. Typically, by paying its workers a salary above the market clearing rate, the firm can achieve high employee productivity, improved workplace cohesiveness, enhanced employees loyalty and responsibility. Furthermore, a favorable pay helps the organization in reducing the level of shirking among its employees. If the firm pays its employees low wages, it runs the risk of creating worker dissatisfaction and diminished employee loyalty which in turn results in high turnover. Typically, high turnovers are expensive and disadvantageous for the firm. Therefore, all factors considered, it is highly imperative for a company to pay its workers a high wage to induce high performance. Generally, this is explained in the adverse selection model, sociological model, labor turnover hypothesis and the shirking model[18]. Through these examples, one can understand that the firm reaps more benefits from paying its workers above average wages since it results in greater productivity while significantly reducing costs. For this reason, it is rational to portend that pay for performance in both public and private sector firms will result in high profitability of organizations. Thus, companies should endeavor to pay its workers an efficiency wage, pay for performance. Bibliography Alfred, Marshall. 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