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Personnel Economics 2 1

Chapter 2:Setting hiring standards

• Miller: “The business world is getting more and more competitive. Labor is 75% of our costs. We must compete with Singapore and Malaysia. We need to hire cheap labor.”

• Smith: “Today, quality is everything. We cannot make good products without good people. We should hire the best, no matter the cost.”

• Who is right?


Hiring

• Which position do you support, and why? Try to explain your answer.

• How does this relate to free trade?


Other questions related to hiring workers

• Are highly skilled workers worth the additional salary?

• Do supply conditions matter?

• How many workers should be hired?

• What if you do not know the productivity of a worker precisely?


Tradeoff between highly and low skilled workers: productivity


Tradeoff between workers: costs


Tradeoff between highly and low skilled workers

• College graduates are more productive, but they cost more• Monthly return per worker:

• 122917 – 2198 = 120719 for HS• 156944 – 3455 = 153489 for College• ==> hire college graduates

• Costs for a sales of 1 Mio• 1 Mio / 122917 = 8.1 HS grads, costs are 17804• 1 Mio / 156944 = 6.4 College grads, costs: 22112• ==> employ HS grads

• What to do?


Use costs per output unit

• Hire group with lowest cost per unit of output!

� Hire High School labor if

H... High School C... College

CH

H C

WW with W as Wage and Q as Output

Q Q<


Alternative solution

• Alternative: Compare relative output to relative price

• ==> hire high school labor if

•

��

��

��

�

��

• Relative output of high school grads. is higherthan their relative price

• Always: relative values not absolute ones areimportant


Trade-off between highly and less-skilled workers

• „Hire the best irrespective of costs“ or „hire the cheapest people“?

� Hire group with lowest cost per unit of output!


Foreign Competition and Labor Markets

• „Foreign Competitors drive our companies out of business because they have access to cheaper labor!“

• But real issue is not whether labor is cheaper, but whether it is more cost-effective!


Labor costs are only relevant if they are related to labor productivity

Personnel Economics 2

An economicmodel

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• � � � �, �, �• H.. High-school, C.. College, K… capital

• Marginal Product of H: ��,�,

��

• Marginal Product of C: ��,�,

��

• Optimality condition:

•

��,�,��

��,�,��

=�

�

��


ProductionTechnology andchoiceof workers

• Is the productivity of workers influenced bythe type of production?

1. Simplest case:Independent across workers(traveling salesman)

2. Team structure, productivity depends on otherworkers

3. Independent across workers, but interaction withcapital


1. Productionindependent acrossworkers

„My firm is a salesforce and that‘s it. We do selling for smallmanufacturers who do not want to have their own sales team. Each salesperson works independently. Most of the time oursalespeople are not selling the same product or even workingfor the same manufacturer as their fellowsalespeople. This isa very small operation. I put the business together myself, andI don‘t think that anyone else could have done it. Most of thebusiness depends on my personal contacts. The onlydisadvantage is that I can‘t expand very much. No one cansubstitute for me and my time is limited. This firm is verybottomheavy. It consists of all salespeople plus me asmanager.“



• Additive production function• � �, � � ��

• Marginal products:

•��,��

�� z-1

•��,��

�� z-1

• Set the proportion of marginal products equal to the proportion of wages



•Set the proportion of marginal products equal to theproportion of wages

• If one is higher than the other, you either employ only H oronly C

H

C

Wa

b W=


2. Workers‘ productivity depends on the skills of other workers

„This firm is engaged in manufacturing small appliances. We find it better to have a combination of worker types. Although the high school grads are cheaper and more cost-effective in the short run, we find that we can‘t keep their skill levels up without some college grads around. The high school grads forget what they knew. The college grads do too, but since they know more, they keep the high school grads sharp. So we like to use both kinds of workers. No managers other than me are necessary. The problem is that I‘m not sure about the appropriate balance.“


Productivityrelationsbetweenworkers

• Jobs are interrelated

• College graduates influence also the work of high-school graduates and vice versa.

• More natural assumption

• Therefore it pays to hire more highly qualifiedworkers when output is interrelated than when it isindependent across workers.

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2. Workers‘ productivity dependson theskills of other workers

• Typical example: Cobb-Douglas productiontechnology

•

• Calculate marginal products:

• …

22

( , )f H C z H Cα β=

1( , )f H CzH C

Hα βα −∂ =

∂


3. Independent production across workers – workers interact with capital

„We are a large department store that has our men‘s dress shirts produced by a factory in Singapore. Each worker must work on a sewing machine, which costs us $5 per day to rent. We can use skilled labor, which produces an average of 4 shirts per day, or we can use professional labor, which produces an average of 6 shirts per day. Skilled labor costs us $5 per hour and professional labor costs us $8 per hour. The sewing machine company says that it will rent us a machine that will double output per worker, but the better machine costs $11 per day to rent. I have two questions. First, should I rent the new machines? Second, what kind of labor should I hire?“



Usually higher skilled labor will use expensive capital more efficiently.

New machine is increasing productivity by 2, but costs even more!



Wage Rates/Hour: Skilled: $ 5.00, Professional: $ 8.00 Capital Cost/Day: Old Machines: $ 5.00, New Machines: $ 11.00

Output Labor

Cost/Day Capital Cost Total Cost Cost/Output

Old Machines

Skilled 4 5

Professional 6 5

New Machines

Skilled 8 11

Professional 12 11




Output Labor

Cost/Day Capital Cost Total Cost Cost/Output

Old Machines

Skilled 4 40 5

Professional 6 64 5

New Machines

Skilled 8 40 11

Professional 12 64 11




Output Labor Cost/Day

Capital Cost Total Cost Cost/Output

Old Machines

Skilled 4 40 5 45

Professional 6 64 5 69

New Machines

Skilled 8 40 11 51

Professional 12 64 11 75




Output Labor Cost/Day

Capital Cost Total Cost Cost/Output

Old Machines

Skilled 4 40 5 45 11.25

Professional 6 64 5 69 11.50

New Machines

Skilled 8 40 11 51 6.38

Professional 12 64 11 75 6.25



Usually higher skilled labor will use expensive capital more efficiently.

Therefore a firm should improve the quality of theworkers that it employs as it increases the amount orquality of its capital stock.

The optimal level of skill rises as the capital/laborratio increases.

Technical change is in favor of qualified labor!


Hiring Standards: Relative Wage and Productivity

• Does the supply of workers make a difference?– In general, NO.

If you can assume a perfect labor market � small firms can get as much as they want at the going wage

Two exceptions:

– Monopsony markets

– Specific labor quality - “thin” market• Search costs must be considered

• Does the financial situation make a difference?


Nobel prize in economics 2010 going to Peter Diamond, Dale Mortensen and Chris Pissarides for

Research on „Markets with Search Costs“

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Number of workers to hire

• Continue to hire workers as long asincrement to profit brought about by hiringthe worker is positive!– Hire as long as marginal revenue > marginal

cost of last worker

• Diminishing marginal product (value) ofworker!


What data do you need?

• Productivity and wages of different types ofworkers, mainly based on education andexperience

• If data are not available?– Estimate relevant numbers

– Experiment and measure productivity


Hiring risky workers

• 2 Sales workers• Johnson � $ 200,000 per year in sales

• Wilson: – Good case (star): $ 500.000– Bad case (disaster): -$ 100.000– Probability of ½ each

• Which one would you choose?



Note: Both workers have the same expected annual productivity!


Suppose...

• Both workers are equally old, have 35 years to work

• It takes one year to determine whether Wilson is a star or a disaster

• Both receive an identical wage (w = 100.000 $ per year)



If two workers have the same expected annual value and the same wage, then it is better to hire the riskier one!

Because:

• Bad outcomes can be mitigated by separation, good outcomes can be magnified through retention of the worker!


Risky workers are more profitable …

• the younger the worker• the higher the potential gain if a star• the lower loss if a disaster• the faster you learn their productivity• the lower the termination costs

• Even if expected annual output of risky worker isbelowthat of safe worker, it may pay to hirehim/her!


Problems withhigh-productivityworkers

• If Wilson turns out to be a star, other firms will poach her (hire her),– In order to keep her, you will have to raise her salary

• Potential solutions:

• Asymmetric information– You may „hide“ the star

• Firm-specific human capital (productivity)– Wilson is not so productive in other firms

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