The existence and prevalence of formal pay systems has been a puzzle among labor economists for quite some time (see Doeringer and Piore 1971). In their seminal paper quoted above, Baker, Gibbs and Holmstrom (1994) discuss and puzzle over the use of pay scales in the firm that they study. While there have been many studies that have documented the various particulars of such systems there are few economic theories that provide a reason for their use.
The consensus among economists is that such policies and practices are ineffectual at best and profit restricting at worst. To my knowledge this is the first paper to suggest that strict wage setting rules have an important role in improving profits and welfare through reducing turnover.
I develop a two period labor turnover model to examine the usefulness of pay restrictions. I assume perfect competition between firms for workers. Any expected future profits are given to the worker at the beginning of the relationship. Therefore any policy that improves expected future profitability and raises future wages improves worker utility.
The need for pay restrictions arises under specific information assumptions. These assumptions are asymmetric information about worker ability, wages as signals, and private worker taste shocks. In this case, the equilibrium wage profile causes higher turnover rates and lower profits than under symmetric information. I show that firms are able to reduce or eliminate this time inconsistency problem through formal pay systems such as pay scales or budget restrictions.
In my model the threat of employee turnover plays a key role. The turnover mechanism I use is relatively unexplored, has appealing properties and provides important new insights on the relationship between the worker and firm. Similar to many other turnover models I assume that there is a match specific rent that is realized after a period. The difference between this model and standard turnover models is the information structure of the firm%worker match. In this model, the match specific taste shock is learned only by the employee after a period of work with his current firm. These private taste shocks have a natural interpretation. They are the workers attitudes toward the non pecuniary aspects of the job. Such non pecuniary aspects might include relationships with co workers, like or dislike of the geographic area or family concerns. This taste shock is considered by the worker when evaluating his quitting decision. This information asymmetry between worker and firm induces a trade%off between retention and ex post profit through the wage offer. Offering a lower wage to the worker increases the rent on the employee if he stays. But, it also reduces the chance that he will accept the offer.
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