who bears the cost of non-wage benefits?

WHO BEARS THE COST OF BENEFITS?

Karen Roberts Michigan State University

NON-WAGE

When we hear a statement like, “The cost of medical care adds $800 to every car Ford produces in the US,” we look out the window at our car, rail at the impenetrable fortress of medical costs, and think of the other things we could do with $800 aside from paying a stranger’s medical insurance. When we follow this train of thought, we are making an assumption that may not be true-that we as consumers are bearing the cost. When the Chairman of General Motors complains that the check written for medical insurance is the largest single check GM writes, the assumption is that medical benefits are being taken out of shareholder dividends (Automotive News 1992). And, when the compensation package in the most recent UAW contract includes no-deductible, no co- pay, full-coverage medical insurance, the membership celebrates because it assumes the company is picking up the tab for their medical care. Who is making the right assumption?

While we may accept that the party who signs any given check is not necessarily the party that actually bears the costs, who truly bears the cost is not always immediately obvious. The purpose of this article is to develop a concep- tual framework for answering the question of who bears the cost of non-wage compensation. Basic economic theory predicts that employees will bear the cost of their own non-wage benefits in the form of lower wages or salaries. However, this prediction has been difficult to document empirically (Smeeding 1983; Mitchell 1989). The analysis presented in this article will present an alternative prediction and show why and when employees may not bear the costs of their own benefits. The paradigm presented here will provide some insights into who else may bear these costs.

This analysis is based on the argument that rigidities exist in the market in the form of institutions or some other type of constraint that prevent or at least slow responses of the various actors in the economy. A useful tool for isolating those rigidities, and the basis for the framework presented in this article, is the concept of elasticity, specifically, the price elasticities of supply and demand.

Direct all correspondence to: Karen Roberts, 402 South Kedzie, School of Labor and Industrial Relations, Michigan State University, East Lansing, MI 48824.

Human Resource Management Review, Copyright 0 1994 Volume 4, Number 2, 1994, pages 197-212 by JAI Press, Inc. AI1 rights of reproduction in any form reserved. ISSN:1053-4822

198 HUMAN RESOURCE MANAGEMENT REVIEW VOLUME 4, NUMBER 2. 1994

Here, elasticities of supply and demand are used to provide a short-hand method for dete~ining who will bear the cost of non-wage benefits. The various actors who might bear the cost of benefits that are considered here include the firm itself in the form of lower profits and/or shareholder dividends; the firm’s customers in the form of higher product prices; and, different types of workers.

In the next section of the article is a description of the basic economic theory that predicts that employees will bear the cost of their own benefits. This is followed by a section that defines price elasticities and examines the determinants and interplay of the elasticities of supply and demand. The concluding section applies the framework to the actors to answer the original question, “Who bears the cost?”

WHY ECONOMISTS EXPECT EMPLOYEES TO PAY FOR THEIR OWN BENEFITS

Assumptions

It is accepted among economists that theory clearly predicts that employees will bear the costs of their own benefits in the form of lower wages (Smeeding 1983; Smith & Ehrenberg 1983; Woodbury 1983). This theoretical prediction is based on the theory of equalizing differences, which when applied to the question of benefits would state that any increase in benefits will be counterbalanced by a comparable decrease in wages (Rosen 1986). This theory rests on certain assumptions. First, it is assumed that employees are utility maximizers and that employers are profit maximizers; in other words, individuals want as much of both wages and benefits as possible and firms want the highest profit possible. Second, it is assumed that both the product market where the employer sells its goods and services and the labor market where the employer hires its employees and the employees sell their labor are both perfectly competitive. There are several attributes to this perfect competition: there are an infmite number of buyers and sellers in any market; information is costless and universally available; and transaction costs are zero so that mobility is perfect.

There are three types of information that are of concern in this framework. First, employees have full information about and understanding of the mix and levels of compensation packages offered by all of the employers in the relevant labor market. Second, employers can costlessly determine how productive each of their employees is as well as how productive any individuals they are consid- ering hiring might be. Finally, consumers have full information about the prices and quality of the goods and services the firm and its competitors are offering in the product market. When coupled with the assumption that there are zero transaction costs in the market and mobility is costless, these assumptions imply several things. First, employees are aware of and can choose to work for the employer who offers the compensation package they prefer.

WHO BEARS THE COST OF NON-WAGE BENEFITS? 199

Second, since employers can perfectly evaluate productivity, they can perfectly gauge the level of compensation to productivity. And, third, consumers will refuse to purchase goods and services from any but the lowest price seller.

The Basic Framework for Arguing Employees Will Bear the Cost

Beginning with the employee perspective, although individuals are thought to all be utility maximizers, they are thought to differ in their preferences as to the wage-benefit mix.1 Part of the differences across individual preferences for various compensation mixes is thought to be a result of features of different types of benefits, in particular their tax treatment ~W~dbury 1983, 1989). There are three different types of benefits ~Mit~hell1989).

The first form of benefits is payment-in-kind, which includes employer payment of the premium for various types of insurance, typically medical, life, disability, and unemployment. Of these, only workers’ compensation and unemployment insurance are mandated by law, and currently, none of these employer-paid premiums are subject to federal income tax for the employee.2 A second form of payment-in-kind is payment for time not worked, usually including vacation, sick, and holiday time. Although there is labor standards legislation that limits how long one can work, there are no legal regulations about pay for time not worked. Payment for time not worked is generally fully taxable.

The second category of benefits is deferred compensation, that is, a promise of future payment made by the employer. This includes most pensions and savings plans. Usually these are taxable but the tax payment is deferred until the employee collects the payment. 3 Employers are not legally required to provide deferred compensation, but once they do, how that compensation is managed is regulated.

The third type of benefits can be characterized as miscellaneous perks, such as employer-provided child care programs, health club mem.berships, tuition reimbursement, discounts on meals or merchandise, employer-provided work clothing, and legal aid. These are not legally required and vary in taxability.

Individuals are thought to differ in their preferences for benefits over wages that are derived in part from the combination of the tax treatment and individual income level as well as from life-cycle stage and personal preference. For example, theory would predict that individuals facing a high marginal tax rate would have a greater preference for non-taxable benefits over wages compared to an individual facing a low marginal tax rate (Woodbury 19891. Similarly, older people are expected to have a greater preference for pensions and health insurance coverage than single younger people (Mitchell 1988). Therefore, theory allows that it is possible that individuals will trade off wages and benefits on some basis other than dollar far dallar, but the relationship between the two must still be negative, that is, one must be willing to give up some of one for some of the other (Smith & Ehrenberg 1983).

The employer is also trading off between wage and non-wage compensation. Recalling the assumption that the employer is facing both a perfectly competi-

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tive labor market and product market, the total value of the compensation package offered by any single employer is constrained by both of these markets to be equal to that offered by all other employers. In other words, there is an equilibrium value for total compensation. The product market provides the mechanism that prevents an employer from offering an above-equilibrium package. Assuming perfect competition in the product market, an above- market compensation package would raise the employer’s costs, which would translate into a higher product price, and consumers would buy the product from one of the firm’s competitors. Perfect competition in the labor market prevents employers from offering a below-market compensation package. Per- fect competition means that there are a sufficient supply of jobs available that offer the market compensation package, and employees will simply go work for employers that offer that level of total compensation.

In the simplest world, employers are indifferent between paying a dollar of benefits and a dollar wages. However, employers may try to structure their compensation package in order to attract or retain certain types of employees (Lazear 1981; Smith & Ehrenberg 1983; Woodbury 1989). Using much the same logic as employees, employers may offer pension to attract more experienced workers, child care to retain women, and so on. In this case, employers are thought to view the value of the benefit they offer as greater than the dollar that wages were reduced to pay for the benefits. Because employers differ in how they value different employees, a variety of mixes of wage/benefit packages are available in the labor market.

The final step in this theory has employees seeking out those employer that offer the wage/benefit mix that maximizes their utility. Since employers are constrained to offer the market level of total compensation even if they can vary the compensation mix to attract certain kinds of workers, employees are seen as paying for their own benefits in the form of lower wages.

AN ALTERNATIVE FRAMEWORK

The key feature of the basic economic model is that employers can not offer a total compensation package that is above or below that offered in the competitive market. Too high a compensation package will result in uncompetitive product prices, driving the employer out of business; and, an employer who offers too low a package will not be able to attract employees. Therefore, any gains employees get in benefits have to be counterbalanced by a loss in wages. In a simple world where all workers and all work are the same, this model would be easy to test-add up the value of the different compensation package available in the labor market and see if they have equal dollar value. However, neither all workers nor work are the same, and worker differences in education, skill, experience, and ability, as well as non-pecuniary features of work (riskiness, aesthetic features, etc.) must be factored into the evaluation of compensation levels. The most common explanation given for why empirical studies have not shown a negative relationship between wages and benefits is


the failure to adequately control for these factors that affect compensation (Olson 1994; Smith & Ehrenberg 1983; Woodbury 1983).

An alternative explanation, the one presented in this article, is that there are rigidities in both the labor and product markets that create opportunities for employees to pass on the costs of benefits to their employers, to the consumers who purchase the goods and services they produce, and/or to other workers, mitigating the negative relationship between wages and benefits.

Using Elasticities of Demand and Supply to Predict Who Will Bear The Cost of Benefits

The framework presented in this article makes use of an empirical tool commonly used in economics, price elasticity.* Formally defined as (dQ/dP)*(P/Q), or the ratio of the percent change in quantity to the percent change in price, elasticity captures the intuitively clear concept of responsiveness. There are elasticities of both supply and demand, which can be thought of as answering the questions, “If the price changes by one percent, by what percent will the quantity supplied change?” and “If the price changes by one percent, by percent will the quantity demanded change?“, respectively.

Conceptually, elasticities are useful because they quantify the degree of mobility in any given market. They show the extent to which the actors in a market can “vote with their feet” in response to a price change. If the demand for some good or service is price inelastic, when prices increase, consumers are stuck paying higher prices. If, on the other hand, demand is elastic, a seller who raises prices will see demand fall off. If the supply is price inelastic, even if prices increase, no more of that good or service will appear in the market; and, if prices fall, the good or service will still be readily available in the marketplace.

An important feature of elasticities is that both supply and demand usually become more price elastic in the long-run than they are in the short-run. The logic is that, both suppliers and consumers have more opportunity to respond to changes in price in the long-run. A familiar example was the consumer response to the sharp increase in oil prices created by the OPEC countries in the early 1970s. Initially, except for conse~ation, consumers had no choice but to pay the higher prices. However, in the long-run, people bought more fuel- efficient cars and reconfigured the heating systems in their homes and of%es to use other fuels, lowering their demand for oil.

That both demand and supply are more elastic in the long-run is true of labor also. For example, for a while in the late 198Os, in certain locations, there were shortages of clerical workers, raising their wages. As personal computer and networking technology advanced and disseminated, the demand for clerical workers fell because employers were able to substitute personal computers for clerical employees.

The concept of elasticity can provide some insight into the question of who bears the cost of benefits because it captures the extent to which employees, employers, and/or consumers can respond to an increase in benefit costs. The

202 HUMAN RESOURCE MANAGEMENT RNIEW VOLUME 4, NUMBER 2.1994

basic principle is that the more inelastic the demand for some good or service, holding everything else constant, the more likely the consumer of that good or service will bear the cost of a price hike; and, the more inelastic the supply of some good or service, again holding everything else constant, the more likely the supplier will bear the cost of a price decrease.

The logic behind this principle is straightforward if one thinks of inelasticity as a synonym for immobility. If demand for some type of labor is inelastic and those employees demand higher benefits, the employer will bear the cost because the employer can not immediately “move away” from its use of that kind of labor. If, on the other hand, the supply of labor is inelastic and there is, for example, an increase in a payroll tax, such as the employer contribution to unemployment insurance, the employee will probably bear the cost of that benefit. While the law may require the employer to pay the cost, because the employee can not “move away” from that employer, the employer can pass the cost of the tax on to the employee in the form of lower wages.5

The assumption that everything else is held constant is important here because, as will be evident below, the determinants of the elasticity of supply and demand for labor do not always work in the same direction. However, these individual determinants of price elasticities do provide specific predictions about who will bear the cost of benefits.

Determinants of the Elasticity of Demand

There are several factors that influence the price elasticities of supply and demand. The factors that determine the price elasticity of demand are summa- rized in what are referred to as the Hicks-Marshall Rules of Derived Demand (Hicks 1966; Marshall 1923). To work through how demand elasticities can be used to determine who will pay for benefits, we will examine a fictitious employer, a university. Two occupations will be examined, a full-time faculty member and a clerical support staff. The benefit under consideration is university sponsored and subsidized child-care.

The first Hicks-Marshall rule asserts that, holding everything else constant, the own-wage elasticity of demand for labor is high when the price elasticity of product demand is high. The underlying logic is that if consumer demand for a product responds to changes in the price of that product, firms will not be able to pass on higher labor costs to the consumer without a fall in product demand. The key questions associated with this rule are: what is produced and what is the market for that product? To keep this example simple, it is assumed that the major product of this university is undergraduate education. Using impres- sionistic empiricism, the demand for undergraduate education appears to be moderately price-elastic. Nationally, tuition has been increasing at rates well above inflation and while universities are having to compete for qualified students more aggressively than in the past (and/or consider lowering admission standards), in general consumer demand for a university degree continues to be strong.6 While there is obviously some upper limit price where consumers/students will decide to forego education, within some price range, they will


continue to purchase education. Applying the first Hicks-Marshall rule, since product demand is moderately inelastic, the university should be able to pass on the part of the cost of the child care to the students in the form of higher tuition and fees.

The second Hicks Marshall rules state that the demand for labor will be more elastic when other factors of production can easily be substituted for labor. The question to be asked at this point is what is the production technology and to what extent can an alternative technology be used that would reduce the demand for labor?

Currently, this university is assumed to use traditional teaching technology. Faculty teach most courses in the classroom, assisted in the larger courses by graduate students. Clerical staff are assigned to academic units on a faculty per capita basis, and except for chairs and directors who have their own admin- istrative assistant, four to five faculty are assigned to each clerical staff person. Clerical staff send out letters, format syllabi, prepare manuscripts, and take phone messages.

Several technological options for teaching courses are available to the university. First, still relying on the face-to-face, class-room model, the university could begin to use graduate students or adjunct faculty to a greater degree. In addition, the university could begin to use a video technology and increase class size without increasing instructor time proportionately. Because each of these options represents some shift in the product, none are perfect alternatives. The availability of these options increases the elasticity of demand for faculty, increasing the likelihood that the faculty would bear the cost of child care in the form of lower wages.

Similar alternative technologies can be considered to perform the duties of the clerical staff. The university could invest in more computer equipment to create electronic offices so that faculty could prepare their own course and research materials. Voice mail could be used for the phones so that any given clerical person could staff more than the current four to five faculty. Based on the ready availability of these technologies, the demand for clerical staff is relatively elastic, suggesting that the clerical workers will also bear the cost of child care.

The third Hicks-Marshall rule states that the demand for labor will be more elastic when the supply of other factors of production is highly elastic. The logic behind this rule is that if the employer can attract alternative factors of production, such as machinery or other workers, by offering a slightly higher price than currently offered, it will be easier for the employer to respond to a compensation hike by replacing those workers with alternative factors of production. The distinction between rule two and rule three is that rule two is ad- dressing the question of technological feasibility and rule three refers to the characteristics of the market for alternative inputs.

There are two types of markets to consider. One is the market for the inputs that would be needed for alternative technologies and the other is the market for perfect substitutes, that is, the markets for faculty and for clerical staff. Beginning with the faculty, if this university is in what is commonly thought of


as a “university town,” the university is often one of the largest if not the largest employer, particularly of people with advanced degrees. Like most university towns, there are probably a ready supply of spouses of graduate students and faculty with advanced degrees who are unable to find full-time employment locally and welcome the opportunity to teach courses on an as- needed basis. This would increase the elasticity of demand for full-time faculty. However, if the faculty are unionized, there may be contractual limitations on the extent to which the university can employ adjunct faculty. This would decrease the elasticity of demand and force the university to bear some of the cost of the child care. If the university decided to move to a video-based teaching model, significant investments would have to be made in fitting classrooms with the necessary equipment. Also, because the university is concerned about the quality of instruction with this teaching model, faculty would have to be trained to present effectively in front of the camera, and a more elaborate office-hours system would have to be developed to answer student questions. Because the equipment and training costs are fairly high, the supply of the inputs needed for this technology could be characterized as relatively inelastic, making the demand for faculty inelastic also.

Turning to the clerical staff example, the availability of computer equipment and the installation of voice-mail technology is relatively inexpensive, raising the elasticity of demand for clerical staff. Again, if these staff are unionized and have contractual work rules that limit the faculty/clerical staff ratio, this will serve to make the demand for clerical staff more inelastic.

The other factor to consider is market for perfect substitutes, in this case, the faculty and clerical labor markets. In general, the labor markets for university faculty are fairly structured. While universities can draw on a national pool, the tenure track system leads them to more commonly promote from within. Therefore, once a faculty person joins a university in a tenure-track position, they become fairly isolated from the external market. From the university’s perspectives as the employer, it is difficult to maintain a credible threat of replacing its current faculty with those from the external market. This increases the inelasticity of demand for faculty, increasing the likelihood that the university will bear the cost of the child care.

The labor market for the clerical staff is likely to be local. Depending on geographical location, there will be some variation in the availability of people who can fill the clerical positions. The major factors that will affect the elasticity of supply of clerical worker are external market conditions (such as the local unemployment rate) and the rigidity of the internal market for clerical staff in the university, such as whether staffing is covered under a collective bargaining agreement. If there is an internal posting requirement, for example, this will isolate the clerical staff from external market competition, increasing the inelasticity of the university’s demand.

The final Hicks Marshall rule states that the demand for labor will be more elastic when the cost of employing the category of labor is a large share of total costs of production. The logic of this rule is that if the larger the share of total cost represented by the cost of a particular type of labor, the larger the effect of


a compensation increase on total costs, making it diflicult to pass the increase on to consumers in the form of higher prices. Wages and salaries account for a major share of the university’s total budget. In total, faculty salaries account for a slightly higher share than clerical. However, for the purposes of the fourth Hicks-Marshall rule, both account for a high enough share to increase the elasticity of demand. This would have the effect of forcing faculty and clerical workers to bear the cost of their own benefits.

The net effect of the four rules on demand for faculty is to make it relatively inelastic, reducing the likelihood that the faculty will bear the cost of child care in the form of lower wages and increasing the likelihood that the students will bear the cost in the form of higher tuition. The application of the four results suggests that the demand for clerical staff is likely to be more elastic, depending on whether or not there is a union (and, of course, if there is one, how strong it is). This more elastic demand for clerical staff suggests that they are more likely than faculty to bear the cost of child care in the form of lower wages. If this were a public university, the taxpayers would also bear some of this cost. Other possible bearers of the cost are those who fund grants or endowments that contribute to the payment of university “overhead.”

Determinants of the Elasticity of Supply of Labor

In an analysis of the welfare implications of raising the marginal income tax, Stern (1977) showed that the welfare loss from an increase in the marginal tax rate was lower the smaller the elasticity of labor supply. The underlying logic was that the less likely it is that individuals will substitute leisure for income, the less likely it is that there will be a drop off in individual work effort if taxes are increased. While there are no commonly accepted rules comparable to the Hicks-Marshall laws for the elasticity for the supply of labor, logic similar to Stern’s used can be used to derive supply-side principles to apply to the question of who bears the costs of benefits. As with demand, the expectation is that the more elastic the supply, the less likely labor will bear the cost of its own benefits in the form of lower wages, holding everything else constant. Again, elasticity can be thought of as an approximation of the ability to move, and the more mobile one is, the more able one is to move rather than pay for benefits in the form of lower wages.

The theory of labor supply is based on consumer theory. Individuals derive utility from two categories of purchases, goods and leisure, which they trade-off to maximize their utility. Both goods and leisure are normal goods, that is, everyone wants more of both. Individuals are constrained in the total amount of goods and leisure they can consume by their wage rate and level of non-wage income.? The price of leisure is one’s wage rate, what one could have earned if one had foregone the leisure and worked. The greater one’s preference for goods, the more one will work, holding income constant. How much any given individual works is the result of the combined effects of that individual’s preferences, how much income one has, and how much he/she can earn in the

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market. These factors form the basis for analyzing the elasticity of labor supply.8

Based on this theory, one factor that will affect the elasticity of supply is one’s preference for leisure relative to goods. The greater one’s willingness to substitute leisure for goods, the more elastic one’s supply. While the word “preference” connotes personal taste for time off because one has hobbies to pursue or little leagues to coach, another driver behind what appears to be one’s preference for leisure may be productivity at home (Gronau 1977). Indi- viduals who are relatively productive at home are more likely to lower their labor supply in response to a wage decrease to spend more time producing at home. A concrete example of this abstraction is the decision to stay home and take care of one’s children after a comparison of one’s own wage to the cost of child care. For many people, especially women, that comparison suggests that they are more productive in the home than in the market.

Applying this notion that the greater one’s preference for leisure the more elastic one’s labor supply to the question of who bears the cost of benefits, the greater the worker’s preference for leisure, the less likely he/she will bear the cost of one’s own benefits in the form of lower wages. As individuals, there is no a priori reason to expect faculty and clerical workers to differ in their preferences. However, gender differences might be a factor in that the majority of faculty are still men, and the male clerical worker is a rarity. Assuming that women still do most of the housework and child care, making them more productive at home, it is plausible that the supply of clerical workers is more wage elastic than that of professors. This would suggest that professors would be more likely than clerical workers to bear the cost of university-provided child care in the form of lower wages.

A second factor that will affect the elasticity of supply is one’s non-wage income level. Holding wages constant, an increase in income will lead one to purchase more leisure, that is, work less. While there is no clear evidence available to support the expectation that there are differences in non-wage income between faculty and clerical workers, there may be some systematic differences. First, it may be that the spouses of faculty systematically earn more than the spouses of clerical workers, one source of non-wage income. Second, because on average faculty salaries are higher than clerical salaries, faculty may have had more opportunity to save, generating more non-wage income through interest. To the extent either of these are true, this would make the supply of faculty more elastic than that of clerical workers, increasing the relative likelihood that clerical workers will bear the cost of the child care in the form of lower wages.

A third factor that will affect the elasticity of supply is the time needed to acquire the education and training needed to do the job. The longer it takes to train for the job, the more inelastic the supply, other things being equal. The logic is that if there is a long training time, even if the offer is increased, new qualified workers can not become available until the training is completed. Applying this to the example developed here, the supply of faculty would be more wage inelastic than that of clerical workers. This would suggest that


faculty would be more likely to bear the cost of child care than clerical workers.

A fourth factor that will affect the elasticity of supply is the applicability of the skills needed for the job to other jobs in the economy. The more fungible the skills, the more elastic the supply of labor, holding everything else constant. The rationale is that if one has skills that can relatively readily be put to alternative use, one can move rather than pay for benefits in the form of lower wages. The fundamental question is does a job exist where one could earn a comparable wage elsewhere in the labor market? In the university example, while this would vary considerably by discipline and individual, on average, faculty are more likely than clerical workers to have transferable skills, making the supply of faculty more elastic than that of clerical workers. This factor would point toward clerical workers having a greater likelihood than faculty of bearing the cost of child care.

Taken together, the supply side factors provide a mixed picture of who will bear the costs of benefits. As was stated earlier, theory provides insight into the nature and direction of market pressures, but little information about magnitudes. Potential to move elsewhere in the labor market or to drop out of the labor market entirely appears to vary across different occupations, and the multiple factors that affect mobility will vary with specifics that can not be detailed in a fictitious example like the one developed here.

Who Will Bear the Costs of Benefits: The Interaction of Supply and Demand

The framework presented here outlines two sets of factors that will affect who actually bears the cost of non-wage benefits. While economic theory predicts that individual employees will bear the cost, compensation experts do not necessarily accept that result (Milkovitch Jz Newman 1987), and the framework presented here argues that that assumption is not necessarily correct. In the example presented here, the factors that affected the elasticity of demand pointed toward demand being more elastic for clerical workers than faculty, suggesting that the university and its consumers would probably bear at least part of the cost of faculty benefits but be able to pass on more of the benefit cost to its clerical employees.

If this example had resulted in the supply of clerical workers being more inelastic than that of faculty (a result which if empirically investigated may be accurate), another possible form of cost shifting might be that the clerical workers would not only bear the cost of their own benefits but also those of the faculty in the form of lower clerical wages. The argument would be that since the demand for faculty is inelastic, the university can not easily pass the cost on to the faculty. However, the product demand is only moderately inelastic so there may be a limit on how much the cost can be passed on to students, grantors, and others who fund the university. Therefore, if the supply of clerical staff is sufficiently inelastic (that is, they have limited ability to “move away” from the university), the clerical workers will bear the cost. Because the example developed here yielded a more mixed prediction about supply elas-


ticities, one could conclude that while the demand elasticities suggest that the university may have to absorb or pass on to consumers the cost of faculty benefits, the supply elasticities suggest that the university can not pass faculty costs on to clerical workers.

Unlike basic economic theory, the framework presented here does not have the satisfying result of definitively identifying a single party who will bear the cost. However, it does provide a useful perspective for thinking about the true incidence of costs and how they might be passed on to actors other than those who actually write the checks. The example here was deliberately simplified so that the elements of the argument could be clearly demonstrated. Obviously, far more information about the nature of both the product and labor markets are needed to fully develop a model that can provide real insight into the actual behavior of costs. The paradigm presented in this article can provide guide- lines for dete~ining what i~ormation is needed to understand who will bear the cost of any proposed changes in the provision of non-wage benefits.

IMPLICATIONS FOR PRACTITIONERS

There are several practical implications for employees and human resource professionals that flow from the framework presented in this article. The first implication is fairly basic: the party who nominally is paying for new or ex- panded benefits is not necessarily the party who actually is bearing the cost. Further, the conventional wisdom from both the economics literature and the compensation literature does not necessarily identify who is actually bearing the cost. Rather, as this framework indicates, one must examine the supply and demand conditions for the type of employee for whom benefits are expected to change.

The framework also provides a list of questions to guide a practical analysis. The Hick-Marshall rules are based on four questions: How competitive is the product market for the firm? How is the product produced and is there some other way to do it with fewer employees? How practical is it to implement that alternative technology? Do benefits account for a large share of total production costs? The supply-side component of the framework also generates a set of questions a practitioner can consider. What are the characteristics of the work force? If forced to bear the cost of non-wage benefits in the form of lower wages, will some of them compare their productivity at home and their preferences for time-off and decide to work less or not at all? Do they have alternative sources of non-wage income that will permit them to leave rather than pay the cost of their own benefits? If existing workers leave, how long will it take to find trained replacements-is the training long and/or is the supply scarce? And, how transferable are the skills of the existing employees to other jobs and are other jobs available? While product and labor market surveys would be necessary to provide definitive answers to these questions, a practitioner who is knowledgeable about the firm’s product markets and production process as well as about the skills and alternatives available to its employees should be

WHO BEARS TtlE COST OF NON-WAKE BENEFITS? 209

able to make educated guesses that will be valuable in setting compensative policy about who will bear the costs for benefits, if reductions are under consideration) of any proposed changes in the compensation package.

Because this framework is built on the concept of elasticity, there is a third implication. Because both supply and demand are more elastic in the long-run than in the short-run, the party who bears the cost may change over time. For example, a collective bargaining agreement that protects or increases non- wage benefits may be a victory for the union in the short-run, but result in lower wages or reduced employment in the long-run.

As an illustration, this framework provides a plausible explanation of the recent emphasis on medical insurance in the contract negotiations in the auto- mobile industry. While there are multiple forces acting on the labor market for auto workers, one possible scenario is that until relatively recently, labor costs, including generous non-wage benefits, could be passed on to the consumer. As the market for cars became more competitive, passing the costs on to consumers has become more difficult. Unionization has provided some protection to employees so that the firm absorbed the cost during early changes in the product market. However, in recent years, auto firms have been able to implement less labor-intensive technologies and subcontract certain operations. Also, the power of unions to protect their membership from substitute factors of production began to decline with the decreases in union density rates. Therefore, demand for auto production workers has become more elastic over time, increasing the firm’s ability to pass on benefit costs to employees. In contrast, the general market for production workers has deteriorated and the highly specialized skills of auto production workers have not proved to be easily transferable to other jobs. As a result, labor supply remains relatively inelastic, reinforcing the employer’s ability to pass on benefit costs to labor. One of the more controversial issues in the recent round of negotiations was over medical insurance. It is not implausible to characterize those negotiations as the firm and the employee fighting over who will bear this cost.

FUTURE RESEARCH

Assum~g the framework presented here is correct, certain outcomes should be observed that would differentiate this framework from standard economic analysis. Because economic theory predicts that benefit costs are born by workers in the form of reduced wages, hypotheses that differentiate between the two frameworks are best phrased in terms of the effects of changes in benefits costs on wages. As mentioned earlier, the assumption that everything else is held constant is made throughout the development of the framework presented in this article, One factor that will affect the level of benefits is the unobservable differences in individual preferences for wages versus benefits. One way to control for individual differences is to examine changes in wages in response to changes in benefits over time for by industry.

The basic difference between the predictions of the two frameworks is that

210 HUMAN RESOURCE MANAGEMENT RRllEW VOLUME 4, NUMBER 2.1994

economic theory predicts that wages and benefits are ready substitutes for one another so that any increase in benefits is matched by a comparable decrease in wages for all workers. The framework presented here predicts differences by worker and employer type. One empirically testable method for differentiating between the two hypotheses is to examine elasticity of wages with respect to benefits as a function of the variables suggested by the framework presented in this paper. Specifically, on the demand side, this elasticity should vary accord- ing to the competitiveness of the product market, the production process used in the firm, the availability and cost of alternative technologies, and labor’s share of total production costs. On the supply side, the education and skill level of the work force and the tightness of the labor market should affect the elasticity of substitution between wages and benefits. Additionally, individual preferences for leisure, non-market productivity, and access to non-wage income should affect this elasticity. Insignificant coefficients on the variables used to measure these concepts would provide support for standard economic predictions and argue against the framework presented here.

To further simplify an empirical examination of the perspective taken in this paper, if the analysis were limited to the effect of cost changes or the introduction of legally mandated benefits, problems associated with cases where labor implicitly or explicitly (in the form of a collective bargaining agreement) decides to bear the cost of benefits because of a preference for those benefits could be avoided. A good example of legally mandated benefits is the contribution made to FICA/OASDI, or what is commonly referred to as the Social Security tax. In principle, Social Security contributions are jointly shared by the employer and employee. Standard economic analysis would argue that although employers nominally paid for half the contribution, in reality employees will bear the cost in the form of lower wages. The framework presented in this article would argue that the actual cost may be shifted elsewhere depending on product and labor market conditions and the degree of mobility of labor.

As of 1994, both parties paid 7.65% of gross earnings up to $60,000. Because both the tax rate and covered earnings rose at a rapid rate during the 1980s and because the rate of change in the costs of those benefits are easily observ- able, an analysis of the effect of changing benefits on wage growth, using industry as the unit of analysis, should not be intractable, and the results of such an analysis should provide insight into the value of this framework for understanding who bears the cost of benefits.

NOTES

1. It is usually assumed that if all other things are equal, when confronted with the choice between a dollar of benefits and a dollar of wages, individuals are thought to prefer wages to benefits because cash gives individuals freedom to purchase the mix of goods and services that will maximize their utility, which may or may not include non- wage benefits. However, all things are not equal, and under certain circumstances, individuals will prefer benefits to wages.


2. Two states, New Jersey and Texas, do not require employers to purchase workers’ compensation insurance. In addition, most states exempt certain types of employers from the obligation to purchase that insurance. However, over 90% of all employees nationally are covered by workers’ compensation. See Chamber of Commerce, 1994 for detail on the exemptions by state.

3. The issue of the taxability of benefits is adds a dimension to the discussion of who bears the cost of different benefits that is beyond the scope of the framework presented in this article. However, it is clear that by exempting or deferring various benefits from federal or state income taxes does suggest that the actual incidence of the cost is partially borne by government and thus the taxpayers.

4. There are several types of elasticities that are used in economic analysis that are not part of the framework discussed here. There is a distinction between income and price elasticities. Price elasticity refers to the change in supply or demand in response to the price of some good or service. Income elasticities refer to the change in supply or demand in response to a change in income of the suppliers or demanders. Only price elasticity is used in the framework provided in this article. In addition, there are two types of price-elasticities, own-price and cross-price. Own-price is the response of supply or demand to a change in the price of a good or service. Cross-price refers to the response to a change in a substitute or complementary good or service (e.g. change in demand for tooth paste in response to a change in the price of tooth brushes). Only own- price elasticities is used in the framework presented here.

5. One counter-argument might be that in reality, wages rarely fall except in cases of give-backs that are well publicized because they are unusual. However, in real terms, it is quite plausible that increase in, for example, health costs, are being paid for in the form of below-inflation wage growth.

6. Still in the spirit of keeping this simple, issues of equity in access to education are not considered here.

7. Unlike ordinary consumer theory, individuals are also constrained by time-only twenty-four hours in a day-but discussion of this constraint does not add anything to this analysis and so it omitted.

8. The gross elasticity of labor supply, (dH/dW)(W/H), is the observed response of supply to a change in wages. Using utility theory, it is the combination of two counter- acting effects. The substitution effect leads people to work more in response to a wage increase because they are substituting work for what is now more expensive leisure (the price of leisure goes up with a wage increase). The second effect, the income effect, leads people to work less due to the increase in the wage rate, because thanks to the wage increase, the individual is wealthier and can now afford more leisure. Theory has no prediction about whether the income or substitution effect will dominate, although most supply curves are drawn as though the substitution effect dominates, that is, people supply more labor as the wage rate increases.

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who bears the cost of non-wage benefits?

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