Edward P. Lazear

Rank-Order Tournaments as Optimum Labor Contracts

This paper analyzes compensation schemes which pay according to an individuals ordinal rank in an organization rather than his output level. When workers are risk neutral, it is shown that wages based upon rank induce the same efficient allocation of resources as an incentive reward scheme based on individual output levels. Under some circumstances, risk-averse workers actually prefer to be paid on the basis of rank. In addition, if workers are heterogeneous in ability, low-quality workers attempt to contaminate high-quality firms, resulting in adverse selection. However, if ability is known in advance, a competitive handicapping structure exists which allows all workers to compete efficiently in the same organization.

Peer Pressure and Partnerships

Partnerships and profit sharing are often claimed to motivate workers by giving them a share of the pie. But in organizations of any significant size, the free-rider effects would seem to choke off any motivational forces. This analysis explores how peer pressure operates and how factors such as profit sharing, shame, guilt, norms, mutual monitoring, and empathy interact to create incentives in the firm. The argument that Japanese firms enjoy team spirit because compensation is linked to overall profitability is analyzed. An explanation for the prevalence of partnerships among individuals in similar occupations is provided.

Job Security Provisions and Employment

European countries have enacted various job security provisions over the last 30 years. Employers are required to pay workers on separation or to give advance notice of termination. In anything less than a perfectly functioning market, there are effects of the provisions on employment. Incumbents are more likely to retain their jobs, but new workers are less likely to be hired. An examination of the European data suggests that severance pay requirements reduce employment.

Culture and Language

Common culture and common language facilitate trade between individuals. Individuals have incentives to learn the other languages and cultures so that they have a larger pool of potential trading partners. The value of assimilation is larger to an individual from a small minority than to one from a large minority group. When a society has a very large majority of individuals from one culture, individuals from minority groups will be assimilated more quickly. Assimilation is less likely when an immigrants native culture and language are broadly represented in his or her new country. Also, when governments protect minority interests directly, incentives to be assimilated into the majority culture are reduced. In a pluralistic society, a government policy that encourages diverse cultural immigration over concentrated immigration is likely to increase the welfare of the native population. Sometimes, policies that subsidize assimilation and the acquisition of majority language skills can be socially beneficial. The theory is tested and confirmed by examining U.S. census data, which reveal that the likelihood that an immigrant will learn English is inversely related to the proportion of the local population that speaks his or her native language.

Balanced Skills and Entrepreneurship

Entrepreneurs are generalists who put together teams of people and assemble resources and capital. To do this effectively, they must have a general set of skills. Individuals may be endowed with a general set of skills, but endowments can be augmented by investment in human capital. It is shown that formal schooling is used to supplement the skill set of those who choose to become entrepreneurs.

Globalisation and the Market for Team-Mates

The globalization of firms is explored at theoretical and empirical levels. The idea is that a global firm is a multicultural team. The existence of a global firm is somewhat puzzling. Combining workers who have different cultures, legal systems, and languages imposes costs on the firm that would not be present were all workers to conform to one standard. In order to offset the costs of cross-cultural dealing, there must be complementarities between the workers that are sufficiently important to overcome the costs. The search for the best practice is analyzed and empirical support from an examination of trading patterns is provided.

Bait and Switch

Sellers sometimes practice a form of false advertising known as bait and switch. A low-priced good is advertised but replaced by a different good at the showroom. the practice is surprising since advertising the wrong good discourages the appropriate buyers from shopping, attracting customers who will be disappointed when they see the good. Firms bait and switch to draw a greater number of shoppers. The cost is that some who would have bought the good that is for sale may not bother to look. Under a variety of conditions, bait and switch is a profitable strategy resulting in a fully rational equilibrium with false advertising.

Personnel Economics: Past Lessons and Future Directions Presidential Address to the Society of Labor Economists, San Francisco, May 1, 1998

In 1987, the Journal of Labor Economics published an issue on the economics of personnel. Since then, personnel economics, defined as the application of labor economics principles to business issues, has become a major part of labor economics, now accounting for a substantial proportion of papers in this and other journals. Much of the work in personnel economics has been theoretical, in large part because the data needed to test these theories have not been available. In recent years, a number of firm‐based data sets have surfaced that allow personnel economics to be tested. Using two such data sets, I give support to the implications of theories that relate to life‐cycle incentives, tournaments, piecework incentives, pay compression, and peer pressure. I conclude that personnel economics is real. It is far more than a set of clever theories. It has relevance to the real world. Additionally, firm‐based data make asking and answering new kinds of questions feasible. The value of research in this area is high because so little is known compared with other fields in labor economics. Questions about the importance of a workers relative position in a firm, about intrafirm mobility, about the effect of the firms business environment on worker welfare, and about the significance of first impressions can be answered using the new data. Finally, I argue that the importance of personnel economics in undergraduate as well as business school curricula will continue to grow.

Chapter 5 Retirement from the labor force

The chapter presents some basic facts on retirement patterns and examines some reasons for the changes in behavior over time and differences across groups. Retirement is an important phenomenon in life-cycle labor supply. Not only does it mean a complete withdrawal from the labor force, but it also turns on a number of institutional facets such as social security and private pensions. The chapter explores a number of theoretical models and discusses empirical results. The chapter presents a close look at pensions and social security and concludes by analyzing life-cycle savings behavior and looking at the status of retirees. The goal of the chapter is to lay out the important issues in retirement behavior, rather than to draw definitive conclusions on the state of knowledge. A quick look at the data reveals that the most important trend among older workers in the United States is the decline in age of retirement. Because there has been a simultaneous increase in the real income of the population, an obvious conjecture is that most of this reflects an income effect that induces workers to take more leisure. The discussion of pensions focuses on one empirical relationship and a number of theoretical ones. The most important empirical point is that the actuarial value of private pensions first rises, but then declines once the worker continues to work beyond a certain point.

The Peter Principle: A Theory of Decline

Some have observed that individuals perform worse after being promoted. The Peter principle, which states that people are promoted to their level of incompetence, suggests that something is fundamentally misaligned in the promotion process. This view is unnecessary and inconsistent with the data. Below, it is argued that ability appears lower after promotion purely as a statistical matter. Being promoted is evidence that a standard has been met. Regression to the mean implies that future ability will be lower, on average. Firms optimally account for the regression bias in making promotion decisions, but the effect is never eliminated. Rather than evidence of a mistake, the Peter principle is a necessary consequence of any promotion rule. Furthermore, firms that take it into account appropriately adopt an optimal strategy. Usually, firms inflate the promotion criterion to offset the Peter principle effect, and the more important the transitory component is relative to total variation in ability, the larger the amount that the standard is inflated. The same logic applies to other situations. For example, it explains why movie sequels are worse than the original film on which they are based and why second visits to restaurants are less rewarding than the first.