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CHAPTER SEVEN
DEFINING COMPETITIVENESS
Overview
This begins Part Three – External Competitiveness: Determining the Pay Level, which contains
two chapters. In Part Two, the focus was on the internal structure or relative value organizations
and markets assigned to different jobs. In Part Three, the authors continue that focus, but also
examine how organizations choose their overall pay level and how and why different
organizations choose different levels. External competitiveness is the term the authors use to
describe the “how much to pay” and “how to pay” questions. It is the next strategic decision in
the total pay model. Chapter Seven discusses choosing the external competitiveness policy, the
impact of that choice, and related theories and research. Chapter Eight has two parts: First, it
discusses how to translate competitiveness policy into pay level and forms. Second, it discusses
how to integrate information on pay levels and forms with the internal structure from Part One.
Chapter Seven, external competitiveness, focuses on pay comparisons outside the organization. It
refers to the pay relationships among organizations—an organization’s pay relative to its
competitors. External competitiveness involves making decisions in two areas: Pay level, and
pay mix. To achieve the objectives stipulated for its pay system, an organization must properly
position both the pay level and the pay mix relative to its competitors.
The key factors that influence external competitiveness are identified and discussed. These
factors include:
Competition in the labor market for people with various skills
Competition in the product and service markets, which affects the financial condition of
the organization
Characteristics unique to each organization and its employees – business strategy,
technology, and the productivity and experience of its work force
Next, the various competitive pay policy options that an organization can choose are explained.
These alternatives include:
Pay above market (lead)
Pay with market (match)
Pay below market (lag)
Flexible policies
Employer of choice
The chapter concludes by examining the consequences of an employer’s choice of a pay policy
on the objectives of the pay model—efficiency, fairness, and compliance.
Learning Objectives:
Define external competitiveness, understanding that both pay-level and pay-mix
decisions focus on two objectives: control costs/increase revenues and attract/retain
employees.
Identify the forces that shape external competitiveness including labor market factors,
product market factors, and organization factors; emphasizing the modifications to the
labor markets supply and/or demand.
Discuss relevant markets and competitive pay policy alternatives, including lead, match
and lag pay-level policies.
Recognize the two major consequences of external competitiveness: It affects operating
expenses and employee attitudes and work behaviors..
Lecture Outline: Overview of Major Topics
I. Compensation Strategy: External Competitiveness
II. What Shapes External Competitiveness?
III. Labor Market Factors
IV. Modifications to the Demand Side
V. Modifications to the Supply Side (Only Two More Theories to Go)
VI. Product Market Factors and Ability to Pay
VII. Organization Factors
VIII. Relevant Markets
IX. Competitive Pay Policy Alternatives
X. Consequences of Pay-Level and Pay-Mix Decisions: Guidance from the Research
XI. Your Turn: Two-Tier Wages
Lecture Outline: Summary of Key Chapter Points
I. Compensation Strategy: External Competitiveness
External competitiveness, the second pay policy, looks at comparisons outside
the organization—comparisons with other employers that hire people with the same
skills.
A major strategic decision is whether to mirror what competitors are paying or to
design a pay package that may differ from competitors but better fits the business
strategy.
External competitiveness is expressed in practice by:
1. setting a pay level that is above, below, or equal to that of competitors.
2. determining the pay mix relative to those of competitors.
Definition: External competitiveness refers to the pay relationships among
organizations—the organization’s pay relative to its competitors.
Definition: Pay level refers to the average of the array of rates paid by an
employer:
(base + bonuses + benefits + value of stock holdings) / number of employees.
Definition: Pay mix is the various types of payments, or pay forms, that make up
total compensation.
Both pay level and pay mix decisions focus on two objectives:
1. Control costs and increase revenues.
2. Attract and retain employees.
A. Control Costs and Increase Revenues
Pay level decisions have a significant impact on expenses. Other things
being equal, the higher the pay level, the higher the labor costs:
Labor costs = (pay level) times (number of employees)
The higher the pay level relative to what competitors pay, the greater the
relative costs to provide similar products or services.
People might think that all organizations would pay the same job the same
rate. However, they do not.
Paying employees above the market can be an effective or ineffective
strategy depending on what the organization gets in return and whether that
return translates into revenues that exceed the cost of the strategy.
Examples in the text include a manufacturing example and a services
example. The text compares labor costs in manufacturing between U.S.
automakers and those in Japan. For the services example, the text compares
labor costs between entrenched U.S. airlines and those for a relative newcomer,
Southwest Airlines.
B. Attract and Retain the Right Employees
One company may pay more because it believes its higher-paid engineers
are more productive than those at other companies.
Another company may pay less because it is differentiating itself on
nonfinancial returns—more challenging and interesting projects, possibility of
international assignments, superior training, more rapid promotions, or even
greater job security.
oDifferent employers set different pay levels; that is, they deliberately choose
to pay above or below what others are paying for the same work. That is
why there is no single “going rate” in the labor market for a specific job.
Not only do the rates paid for similar jobs vary among employers, but a
single company may set a different pay level for different job families.
Exhibit 7.3 makes two points:
oCompanies often set different pay-level policies for different job families.
oHow a company compares to the market depends on what competitors it
compares to what pay forms are included.
The data in Exhibit 7.3 is based on comparisons of base wage. A look at
total compensation in the bottom of the exhibit shows the emergence of a
different pattern.
Exhibit 7.4 shows that organizations can and do vary in how closely they
match the “going rate”.
oThere is no single “going mix” of pay forms, either.
oExhibit 7.4 compares the pay mix for the same job at two companies in the
same geographic area.
oBoth companies offer about the same total compensation. Yet the
percentage allocated to base, bonuses, benefits, and options are very
different.
II. What Shapes External Competitiveness?
Exhibit 7.5 shows the factors that affect decisions on pay level and pay mix.
The factors include:
1. Competition in the labor market for people with various skills.
2. Competition in the product and service markets, which affects the financial
condition of the organization.
3. Characteristics unique to each organization and its employees, such as its business
strategy, technology, and the productivity and experience of its work force.
These factors act in concert to influence pay-level and pay-mix decisions.
III. Labor Market Factors
Economists describe two basic types of markets:
oQuoted price—stores that label each item’s price or ads that list a job opening’s
starting wage are examples of quoted-price markets. Amazon is an example of a
quoted price market.
oBourse—allows haggling over the terms and conditions until an agreement is
reached. eBay is an example of a bourse market.
In both the bourse and the quoted market, employers are the buyers and the
potential employees are the sellers. If the inducements (total compensation) offered by
the employer and the skills offered by the employee are mutually acceptable, a deal is
struck.
All this activity makes up the labor market; the result is that people and jobs
match up at specified pay rates.
A. How Labor Markets Work
Theories of labor markets usually begin with four basic assumptions:
1. Employers always seek to maximize profits.
2. People are homogeneous and therefore interchangeable.
3. The pay rates reflect all costs associated with employment.
4. The markets faced by employers are competitive, so there is no advantage
for a single employer to pay above or below the market rate.
Although these assumptions oversimplify reality, they provide a
framework for understanding labor markets.
Organizations often claim to be “market-driven”; that is, they pay
competitively with the market or even the market leaders.
Understanding how markets work requires analysis of the demand and
supply of labor.
oThe demand side focuses on the actions of employers: how many new hires
they seek and what they are willing and able to pay new employees.
oThe supply side looks at potential employees: their qualifications and the
pay they are willing to accept in exchange for their services.
Exhibit 7.6 shows a simple illustration of demand and supply for business
school graduates.
oIn the exhibit, the market rate is where the lines for labor demand and labor
supply cross.
B. Labor Demand
If $40,000 is the market-determined rate for business graduates, how many
business graduates will a specific employer hire? The answer requires an
analysis of labor demand.
In the short term, an employer cannot change any other factor of
production (i.e., technology, capital, or natural resources). Thus, its level of
production can change only if it changes the level of human resources.
Under such conditions, a single employer’s demand for labor coincides
with the marginal product of labor.
Definition: The marginal product of labor is the additional output associated
with the employment of one additional person, with other production factors
held constant.
Definition: The marginal revenue of labor is the additional revenue generated
when the firm employs one additional person, with other production factors held
constant.
C. Marginal Product
The marginal product is the change in output associated with the
additional unit of labor.
Diminishing marginal productivity results from the fact that each
additional employee has a progressively smaller share of the other factors of
production with which to work.
In the short term, the other factors of production are fixed. Until those
factors are changed, each new hire produces less than the previous hire.
The amount each hire produces is the marginal product.
D. Marginal Revenue
Marginal revenue is the money generated by the sale of the marginal
product, the additional output from the employment of one additional person.
An employer will continue to hire until the marginal revenue generated by
the last hire is equal to the costs associated with employing that person.
Because other potential costs will not change in the short run, the level of
demand that maximizes profits is that level at which the marginal revenue of the
last hire is equal to the wage rate for that hire.
Exhibit 7.7 shows the connection between the labor market and the
conditions facing a single employer.
oOn the left is the market level supply and demand model from Exhibit 7.6,
showing that pay level ($40,000) is determined by the interaction of all
employers’ demands for business graduates.
oThe right side of the exhibit shows supply and demand for an individual
employer.
oThe point on the graph at which the incremental income generated by an
additional employee equals the wage rate is the marginal revenue product.
A manager using the marginal revenue product model must do only two
things:
1. Determine the pay level set by market forces, and
2. determine the marginal revenue generated by each new hire.
The model provides a valuable analytical framework, but it oversimplifies
the real world.
Neither the marginal product nor the marginal revenue is directly
measurable.
E. Labor Supply
The behavior model (of potential employees) assumes that many people
are seeking jobs, that they possess accurate information about all job openings,
and that no barriers to mobility (discrimination, licensing provisions, or union
membership requirements, etc.) exist.
Just as with the analysis of labor demand, these assumptions simplify the
real world.
oAs the assumptions change, so does the supply.
IV. Modifications to the Demand Side
Economic models must frequently be revised to account for reality.
When people change their focus from all the employers in an economy to a
particular employer, models must be modified to help people understand what actually
occurs.
A particularly troublesome issue for economists is why an employer would pay
more than what theory states is the market-determined rate. Exhibit 7.8 looks at three
modifications to the model that address this phenomenon:
oCompensating differentials
oEfficiency wage
oSignaling
A. Compensating Differentials
More than 200 years ago, Adam Smith argued that individuals consider the
“whole of the advantages and disadvantages of different employments” and
make decisions based on the alternative with the greatest “net advantage.”
If a job has negative characteristics—that is, if the necessary training is
very expensive, job security is tenuous, working conditions are disagreeable, or
chances of success are low—then employers must offer higher wages to
compensate for these negative features. Such compensating differentials
explain the presence of various pay rates in the market.
Although the notion is appealing, it is hard to document, due to the
difficulties in measuring and controlling all factors that go into a net-advantage
calculation.
B. Efficiency Wage
According to efficiency-wage theory, high wages may increase efficiency
and actually lower labor costs if they:
oAttract higher-quality applicants.
oLower turnover.
oIncrease worker effort.
oReduce “shirking.”
oReduce the need to supervise employees (academics say “monitoring”).
Basically, efficiency increases by hiring better employees or motivating
present employees to work smarter or harder.
The underlying assumption is that pay level determines effort—again, an
appealing notion that is difficult to document.
Utility theory can help compare the costs and benefits of different pay
level policies. See Appendix 7-A – Utility Analysis.
There is some research on efficiency-wage theory, however.
oOne study looked at shirking behavior by examining employee discipline
and wages in several auto plants. Higher wages were associated with lower
shirking, measured as the number of disciplinary layoffs.
oResearch shows that higher wages actually do attract more qualified
applicants. But higher wages also attract more unqualified applicants. So an
above-market wage does not guarantee a more productive workforce.
oSome research evidence says that an above-market wage allows an
organization to operate with fewer supervisors.
An organization’s ability to pay is related to the efficiency wage model.
Firms with greater profits than competitors are able to share this success with
employees.
oThis could be done via “leading” competitors’ pay levels and/or via bonuses
that vary with profitability. Academics see this as “rent sharing.”
oRent is a return (profits) received from activities that are in excess of the
minimum (pay level) needed to attract people to those activities.
The theories discussed so far assume that the pay level includes the value
of different forms. Abstracted away is the distinct possibility that some people
find more performance-based bonus pay or better health insurance more
attractive.
Signaling theory is more useful in understanding pay mix.
C. Sorting and Signaling
Sorting is the effect that pay strategy has on the composition of the
workforce—who is attracted and who is retained.
Signaling is a closely related process that underlies the sorting effect.
Signaling theory holds that employers deliberately design pay levels and mix as
part of a strategy that signals to both prospective and current employees the
kinds of behaviors that are sought.
Viewed through a marketing lens, how much to pay and what pay forms
are offered establishes a “brand” that sends a message to prospective employees,
just like brands of competing products and services.
An employer that combines lower base pay with high bonuses may be
signaling that it wants employees who are risk takers.
A study of college students approaching graduation found that both pay
level and mix affected their job decisions. Students wanted jobs that offered
high pay, but they also showed a preference for individual-based (rather than
team-based) pay, fixed (rather than variable) pay, job-based (rather than
skill-based) pay, and flexible benefits.
Signaling works on the supply side of the model, too, as suppliers of labor
signal to potential employers. People who are better trained, have higher grades
in relevant courses, and/or have related work experience signal to prospective
employers that they are likely to be better performers.
V. Modifications to the Supply Side (Only Two More Theories to Go)
Two theories shown in Exhibit 7.9—reservation wage and human capital—
focus on understanding employee behavior: the supply side of the model.
A. Reservation Wage
Economists describe pay as “noncompensatory.” What they mean is that
job seekers have a reservation wage level below which they will not accept a
job offer, no matter how attractive the other job attributes.
Other theorists go a step further stating that some job seekers—satisfiers—
take the first job offer they get where the pay meets their reservation wage.
A reservation wage may be above or below the market wage.
The theory seeks to explain differences in workers’ responses to offers.
B. Human Capital
The theory of human capital is based on the premise that higher earnings
flow to those who improve their potential productivity by investing in
themselves (through additional education, training, and experience).
The theory assumes that people are in fact paid at the value of their
marginal product.
In general, the value of an individual’s skills and abilities is a function of
the time, expense, and effort to acquire them. Consequently, jobs that require
long and expensive training should receive higher pay levels than jobs that
require less investment.
A number of additional factors affect the supply of labor:
oGeographic barriers to mobility among jobs,
oUnion requirements,
oLack of information about job openings,
oThe degree of risk involved, and
oThe degree of unemployment.
Nonmonetary aspects of jobs (e.g., time flexibility) may also be important
aspects of the return on investment.
