Lecture 21 - Lecture 21 Lecture 21 Compensation Roadmap...

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ecture 21 Lecture 21 Compensation
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oadmap Roadmap he Basic Employment Contract The Basic Employment Contract • Moral Hazard • Asymmetric Information • Self-enforcing Contracts
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uestion Question • Suppose you own a farm and you have five workers. – How would you compensate them? • (e.g. piece rate, pay by the hour, pay a monthly salary, offer a percentage of the profits, some ombination have a competition) combination, have a competition) – What considerations do you take into account? hat makes you prefer one method over What makes you prefer one method over another? • How easy is it to see what they do. Monitoring costs. Complementarities in production across workers.
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he Employment Contract The Employment Contract • The employment relationship is a contract between the employer (principal) and the employee (agent). • The employee is hired to advance the mployers objectives in exchange for employers objectives in exchange for wages and other benefits. here are often understandings (implicit or • There are often understandings (implicit or explicit) that if the worker works hard, they ill be rewarded with a raise or promotion will be rewarded with a raise or promotion or a bonus (or not fired).
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ormal Contracts Formal Contracts ays out explicitly all that each party Lays out explicitly all that each party promises to do and what will happen if either party fails to perform as promised. • Once signed, a formal contract cannot be abrogated by either party without a penalty. • A complete contract: lays out exactly what will happen is every contingency of the world (virtually impossible).
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Implicit (incomplete) Contracts • Rarely are all the specific tasks an employee must perform spelled out in advance. – This would give up great flexibility. ould require constant renegotiation when Would require constant renegotiation when conditions change. plicit contracts are based on a mutual Implicit contracts are based on a mutual implicit understanding. mployees must “work hard” Employees must work hard . – Employees rewarded for “doing a good job”. • But what do these terms mean?
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he Standard Wage Contract The Standard Wage Contract the standard wage contract employees In the standard wage contract, employees receive a wage W for an hours work. • This time-based pay may raises a problem of “moral hazard” . – Once the wage contract is signed, workers have no incentive to work hard since there is no additional reward for expending extra ffort effort.
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efinition Definition • Moral hazard: oral hazard arises because an individual (or • Moral hazard arises because an individual (or institution) does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some sponsibility for the consequences of those actions responsibility for the consequences of those actions.
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This note was uploaded on 01/09/2010 for the course ILRLE 2400 at Cornell University (Engineering School).

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Lecture 21 - Lecture 21 Lecture 21 Compensation Roadmap...

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