This is “Employee Motivation”, section 5.10 from the book Managerial Economics Principles (v. 1.0).
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Earlier we considered how to motivate divisions within a large organization with appropriate transfer pricing. How about motivation within the divisions? As noted in the introduction to this chapter, in recent decades economists have addressed this matter from a new perspective.
The traditional approach to motivation inside a division or modest-sized business was typically regarded as matters of organizational design and organizational behavior. Once the employee agreed to employment in return for salary or wages and benefits, his services were subject to direction by management within the scope of human resource policies in terms of hours worked and work conditions. Ensuring good performance by employees was basically a matter of appropriate supervision, encouragement, and feedback. In cases where employees were not performing adequately, they would be notified of the problem, possibly disciplined, or even dismissed and replaced. From this perspective, managing employees is much like managing military troops, differing largely in terms of the degree of control on the individual’s free time and movements.
The new perspective on employee motivation is to consider the employee more like an individual contractor rather than an enlisted soldier. Just as microeconomics viewed each consumer as an entity trying to maximize the utility for his household, an individual employee is a decision-making unit who agrees to an employment relationship if he believes this is the best utilization of his productive abilities. The challenge for business management is to structure compensation, incentives, and personnel policies that induce employees to contribute near their productive capacities but not overreward employees beyond what makes economic sense for the business.
One contribution from this economic perspective is the notion of an efficiency wageAn incentive to induce an employee to be productive and retain his or her job that is based on a value somewhat above the employee's marginal revenue product..See Milgrom and Roberts (1992). The classical approach to setting wages is that the wage paid to an employee should be no more than the marginal revenue product corresponding to her effort. However, if an employee is paid barely what her efforts are worth to the firm at the margin and if there is a competitive market for the employee’s services in other firms, the employee may not be motivated to work at maximum capacity or avoid engaging in behaviors that are detrimental to the firm because she can earn as much elsewhere if she is dismissed. An efficiency wage is a wage that is set somewhat above the marginal revenue product of the employee to give the employee an incentive to be productive and retain this job because the employee would sacrifice the difference between the efficiency wage and marginal revenue product if she sought employment elsewhere. This incentive is worthwhile to the firm because it avoids the transaction costs of finding and hiring a new employee.
Another contribution of this economic viewpoint of employee motivation is an examination of employee contracts to deal with what is called the principal-agent problemThe situation that results when an employer is not able to monitor all of an employee's actions and thus has insufficient information about whether an employee takes actions that are not necessarily what the employer would want.. In this context, the hiring business is a principal that hires an employee (agent) to act on its behalf. The problem occurs when the agent is motivated to take actions that are not necessarily what the employer would want, but the employer is not able to monitor all the activities of the employee and has insufficient information.
In the employment relationship the employer evaluates the employee on the basis of her contribution to profit or other objective of the firm. However, the employee evaluates her activities based on the amount of effort involved. To the degree that employees see their compensation and incentives connected to the intensity of effort, the more likely the employee will invest additional effort because there is reduced risk that her efforts will go unrewarded.
For example, if employee incentives are based on the overall performance of a team of employees without any discrimination between individual employees, there is an incentive for employees to shirk in performance of their jobs because they still benefit if others do the work and they do not risk putting in an extra effort to see the reward diminished by sharing the incentives with others who did not put in the same effort. The informativeness principleThe suggestion that measures of performance that reflect individual employee effort be included in employee contracts. suggests that measures of performance that reflect individual employee effort be included in employee contracts.A good description of the informativeness principle appears in Samuelson and Marks (2010).
A third interesting contribution of this perspective on employee motivation is the concept of signalingObservable actions that a potential employee takes that help distinguish him or her as a high-quality worker..Nobel laureate Michael Spence (1974) introduced the economics of signaling. When employers hire, they face a pool of possible employees. Some employees will perform well, whereas others will not due to either lack of skills or lack of character. In the interview process, the employer will try to assess which applicants will be good employees, but these evaluation processes are imperfect. The real intentions of the applicant if and when he becomes an employee are largely private information until the person is actually hired and on the job for a while. As a result, employers face an adverse selection problem similar to what was discussed earlier in the context of vertical integration and will often protect against the risk by lowering the compensation offered, even though they would be willing to pay a motivated, qualified employee more.
One response to the adverse selection problem by the employee is to take actions on his own that will help distinguish him from others in the applicant pool, which are observable and serve as a signal to the employer. Seeking a college degree has been cited as a kind of signal. Even though much of what the employee learned as part of obtaining the college degree may be of little use in the prospective employment relationship, the fact that the applicant was willing to endure the cost and effort for a college degree, particularly a degree supported with good grades, is evidence that the applicant is more likely to be a dedicated and competent employee.
Applicants for employment or hire often have several employment relationships over time. By attaching importance to reputation, employers can both motivate employees to be more diligent in their current positions and establish a mechanism to help distinguish high-quality workers from low-quality workers in future hiring.