Personnel economics


Personnel economics has been defined as "the application of economic and mathematical approaches and econometric and statistical methods to traditional questions in human resources management". It is an area of applied micro labor economics, but there are a few key distinctions. One distinction, not always clearcut, is that studies in personnel economics deal with the personnel management within firms, and thus internal labor markets, while those in labor economics deal with labor markets as such, whether external or internal. In addition, personnel economics deals with issues related to both managerial-supervisory and non-supervisory workers.
The subject has been described as significant and different from sociological and psychological approaches to the study of organizational behavior and human resource management in various ways. It analyzes labor use, which accounts for the largest part of production costs for most firms, by formulation of relatively simple but generalizable and testable relationships. It also situates analysis in the context of market equilibrium, rational maximizing behavior, and economic efficiency, which may be used for prescriptive purposes as to improving performance of the firm. For example, an alternate compensation package that provided a risk-free benefit might elicit more work effort, consistent with psychologically-oriented prospect theory. But a personnel-economics analysis in its efficiency aspect would evaluate the package as to cost–benefit analysis, rather than work-effort benefits alone.
Personnel economics has its own Journal of Economic Literature classification code, JEL: M5 but overlaps with such labor economics subcategories as JEL: J2, J3, J4, and J5. Subjects treated include:
  • firm employment decisions and promotions, including hiring, firing, turnover, part-time and temporary workers, and seniority issues related to promotions
  • compensation and compensation methods and their effects, including stock options, fringe benefits, incentives, family support programs, and seniority issues related to compensation
  • training, especially within the firm
  • labor management, including team formation, worker empowerment, job design, tasks and authority, work arrangements, and job satisfaction
  • labor contracting devices, including outsourcing, franchising, and other options.

    History of Personnel Economics

The field can be traced back to 1776 when Adam Smith, a British economist, suggested that within the labor market equilibrium, a trade-off between a worker's wages and non-monetary working conditions could exist. However, Personnel Economics did not gain prominence until 1987, when the Journal of Labor Economics published 10 articles on the field. During the 1990s, Personnel Economics gradually became more empirical-based, whereas previously the field was more heavily theoretical. Personnel Economics is now considered a branch of Labor Economics. In 1998, Edward Lazear described it as "the use of economics to understand the internal workings of the firm." With the availability of new data, the field has evolved to have more practical use. Econometric techniques have played a significant role in the field's development, with data being used to analyze personnel records and other human resource data. This is known as Insider Econometrics.

Theory, Testing, and Possible Uses

Personnel economics began to emerge as a distinct field from a flurry of research in the 1970s that sought to answer the questions of how prices of goods and services traded within a firm are determined. An early difficulty that the subject addressed is possible differences between the interests of an employer considered as wanting cost-free output and employees as wanting cost-free income. The relationship is represented at a general level in the principal-agent problem whose solution is the firm modeled as a set of contracts for efficiently allocating risk and monitoring the performance of the production team and its members. Many questions about wage determination and the relationship between wages and productivity in a firm or government enterprise were raised as a result. The subject was developed in addressing those questions, including examination of pay structure and promotions within hierarchical organizations.

Major theories of the subject developed in the late 1970s and 1980s from the research of Bengt Holmström, Edward Lazear, and Sherwin Rosen to name but a few. Research threads included analysis of:
  • Compensation according to piece rate, that is contributions to output, both when output is easily measured or when only the worker knows the difficulty of the job and his own contribution,
  • efficiency-improving contracts as constrained by noise in production contributions, moral hazard, and distribution of risk aversion,
  • compensation based on principles of tournament theory as a possibly more efficient substitute for piece-rate compensation.
From the later 1980s, researchers began to forge closer links with experimental economics, including generation of data to test the theories in the field. Other empirical studies conducted then utilized data from sports. and company records on their suppliers' performances.
From the 1990s, there was a further surge of empirical tests of the theory from wider availability of personnel records of large companies to researchers and interest in the relation between compensation and productivity and the implications of imperfect labor markets and rent-seeking behavior for the subject.
A retrospective collection of the personnel economics-literature is in Lazear et al., ed., Personnel Economics, Elgar, with 43 articles dating from 1962 to 2000.
Two millennial articles by a contributor to the subject argued in the course of review and assessment to the conclusions that:

Gift Exchange Theory

The Gift Exchange Theory, also referred to as the fair-wage theory, applies when employees are provided with better wages than they could receive at another firm in exchange for a higher work standard.
In 1993, a laboratory experiment was conducted to test the effects that the Gift Exchange Theory had on employee effectiveness. Contrary to predictions, it was found that most employers were offering higher than market clearing wages. On average, the higher wage was requited by a higher output, often making it very profitable for employers to offer high wage contracts. Paying for an employee's performance can lead to increased productivity and higher competition surrounding highly skilled workers who will want to work for employers who pay for performance.

Tournament Theory

was proposed by Edward Lazear and Sherwin Rosen. The theory addresses how pay raises are associated with promotions. The theory’s main point is that promotions are a relative gain. Regarding compensation, the level of compensation must be strong enough to motivate all employees below the level of compensation who aim to be promoted. If the pay spread between promotions is larger, the incentive of employees to put in effort will also be larger. The desired outcome from this would be to see employees performing at a quality and producing a quantity of output that the organization deems desirable. Compensation is also not necessarily determined by the conception of productivity. Employees are promoted based on their relative position within the organization and not by their productivity. However, productivity does hold some weight when considering promotion.
Advantages of Tournament Theory:
  • Incentive Performance: Workplaces that promote competition among employees may benefit from incentivized performance. Studies have shown that competition within the workplace helps boost performance because employees value the idea of being better than the rest.
  • Matching Workers and Jobs: Under Tournament Theory, workers are matched to their appropriate job. Firms with a tournament structure in the workplace are more likely to hire more competitive and highly-skilled workers, and firms with a workplace based structured around equity are more likely to hire less competitive and lower-skilled workers.
Disadvantages of Team Production:
  • Inequality within the Workplace: Workplaces that are based around a tournament structure are prone to creating an unequal working environment. If workers are paid based on their performance, it has the potential to leave some employees worse off than others. This type environment could also be more demotivating for under-performing workers and more motivating for over-achieving workers which results in a bigger payoff gap between the two types of workers over time.
  • Unethical Behavior: A problem with competition in a workplace is that it is prone to promoting unethical behavior within employees. As they are competing against each other, they may succumb to inappropriate actions that can hurt another employee's standing within the company. For example, employees may sabotage each other or take credit for others' work.

    Principal-Agent Problem

The Principal-Agent Problem is based on the relationship between an employer and an employee. In this case, the employer relies on their employees to maximize the firm’s utility. In practice, incentives are sometimes misaligned between the principal and the agent. This occurs due to differing goals between the two, this can lead to adverse selection for the principal when hiring an agent, they cannot fully evaluate an agent's skills and moral hazard for the agent when presented with more information than the principal.

Approaches to Resolving Conflict

  1. Fixed payment with monitoring
  2. * Fixed salaries are provided to agents while their performance is under observation. Fixed payment with monitoring is an approach where fixed salaries are given to agents while their performance is being observed. The advantage of this approach is that it reduces the risk of shirking by the agent as their work is being monitored.
  3. * Disadvantages: Shirking, monitoring costs and adverse selection. However, it also has some disadvantages, such as monitoring costs, adverse selection, and the possibility of an inequitable pay system. The cost of monitoring the agent's work can be expensive, and this may not be feasible for some firms. Additionally, adverse selection may occur as agents may choose to work in firms where their performance is not as heavily monitored. In terms of inequitable pay, fixed payment with monitoring may not always be reasonable as it does not take into account delays or interruptions that may be outside of the agent's control.
  4. Incentive pay without monitoring
  5. * Payment is correlated with output and performance is not monitored. Incentive pay without monitoring is an approach where payment is correlated with output, and performance is not monitored. This approach allows for greater flexibility, but it also has some disadvantages, such as shirking and inequitable pay. As the agent's pay is directly correlated with their output, there is a greater incentive for the agent to perform well.
  6. * Disadvantages: Inequitable pay and compensation. However, without monitoring, there is a risk of shirking, where the agent may not act in the best interest of the principal/firm. Additionally, an inequitable pay system may arise if delays or interruptions occur, and the agent is still expected to produce the same amount of output.
Shirking: If agents are guaranteed pay, they may lack the motivation to act in the best interest of the principal/firm. This can lead to the agent not performing at the expected level or engaging in behavior that is not aligned with the principal's goals.
Monitoring Costs: Monitoring and measuring agent performance can be costly for the principal, as it requires additional resources and time. The costs associated with monitoring can also be a disincentive for the principal to invest in monitoring, leading to a lack of oversight and potential issues with agent behavior.
Adverse Selection: If the principal heavily monitors and controls agent behavior, highly skilled agents may choose to work elsewhere where their skills are better appreciated and they have more autonomy. This can result in the principal being left with lower quality agents who are willing to work under these conditions.
Inequitable Pay: Fixed payment with monitoring can be prone to delays and interruptions, making it unreasonable to punish agents for issues outside of their control. This can lead to inequitable pay and compensation for agents who are performing well but face delays or interruptions. Additionally, incentive pay without monitoring can lead to inequitable pay if the correlation between output and pay is not properly calibrated.
Compensation: Compensation is an approach where the principal may have to provide agents with a risk premium as they bear a risk with payment. This approach acknowledges that agents take on some risk in their work and may need to be compensated accordingly. However, this approach may not always be feasible as it may increase the costs for the principal/firm.