Chapter 02 – The Psychology and Economics of Employee Benefits
Chapter 02 The Psychology and Economics of Employee Benefits
I. Learning Objectives (use PP 2.2)
2. Employee benefits as part of the psychological contract and how some employee
expectations about benefits might be formed
4. The economic rationales for employers to offer a mixture of cash and benefits in a
compensation package
6. How changes in benefits costs affect employer profits and the amount of cash wages
7. How changes in the value that workers place on their benefits package influence their
II. The Psychology of Employee Benefits
III. Employment Relationship as Social Exchange (use PP 2.4)
1. Social exchange: All social behavior can be seen as “an exchange of activity (work
effort), tangible (visible performance) or intangible (motivation and commitment), and
more or less rewarding or costly (pay and benefits), between at least two persons
A. How employee benefits constitute social exchange (use PP 2.5)
2. The employment relationship can be said to constitute both economic exchange and
social exchange.
3. If an employer can provide an employee with benefits suitable to an employee’s
evolving needs, the employee is likely to reciprocate with increased work effort and
B. Workforce changes and the employment relationship (use PP 2.6)
1. Jobs are no longer characterized by traditional job security, strong loyalty to the
2. Apart from economic and market challenges, the workforce in the U.S. and other
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3. Two strong contingencies are shaping the employment relationship in terms of
employee benefits today. The first is the economic challenges faced by the company.
IV. Psychological Contracts
A. Overview (use PP 2.7)
1. A psychological contract has been defined as an employee’s subjective perceptions of
2. Employee benefits can be a part of the psychological contract that employees hold
3. Psychological contracts result in employees holding a range or continuum of
4. The continuum of expectations that employees hold from an employer can be seen as
ranging between two ends: transactional psychological contracts and relational
psychological contracts (see Table 2.2) (use PP 2.8)
a. Toward the transactional end of the continuum, employees’ expectations from
the employer are more economic and extrinsic in nature. Thus, employees’
b. On the other hand, toward the relational end of employees’ expectations from
the employer that might be either economic or non-economic, but they are
5. Employee benefits practices can be seen to fulfill both transactional and relational
expectations of employees (see Exhibit 2.1) (use PP 2.9)
a. Health insurance and other legally required benefits would form a part of
employees’ transactional expectations from the employer.
B. Psychological contract development
1. Most psychological contracts take shape in the pre-employment phase, when people
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2. Ultimately, what an employee learns about employer’s benefits practices will form a
3. Employees can form expectations that comprise their psychological contracts from
4. Psychological contracts are flexible in nature, undergoing constant change based on
2.12)
a. If employees hold relatively stable expectations from employers, any
changes in the policies and practices of the company will lead to the
C. Psychological contract violation (use PP 2.13)
1. A violation of the psychological contract occurs when an employee perceives a
2. If a company withdraws or changes certain benefits, and those practices constituted
3. Violations of psychological contracts are different from unmet expectations. The
4. There may be two basic causes for violations of psychological contracts: reneging
and incongruence.
a. When a company deliberately breaks a promise to employees, either
D. Employee benefits as constituting psychological contracts
1. If employee benefits are a part of employees’ psychological contract, then it is
2. Violations can be avoided by clear communication and education about the nature
to have expectations from the employee.
5. Employee benefits have, over the years, become a growing source of employees’
psychological contract violations.
Chapter 02 – The Psychology and Economics of Employee Benefits
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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
a. Expectations about employees’ cost burden, needs, and benefits design will
all affect employee satisfaction.
V. The Economics of Employee Benefits
VI. Why Do Employers Offer Benefits
A. 3 Primary Reasons (use PP 2.15)
2. It helps in recruiting certain types of workers
B. Cost Advantages (use PP 2.16)
1. Benefits, like health insurance are cheaper for the employer to purchase for a group
than employees can purchase individually
2. EXAMPLE: Health insurance costs $1000 per employee, if purchased by employer
that employs 500. Individually, the same policy would cost each employee $2500.
3. Reasons why group insurance rates decrease as group size increases
a. Insurance becomes less risky to provide
4. Individual policyholders and small groups of policyholders may have to undergo
medical underwriting
5. The larger the group the less likelihood of adverse selection
a. The condition where the insurance pool attracts only high-risk individuals
6. Experience ratings, information from medical underwriting, determine policyholders’
risk profile and policy rates (use PP 2.19)
C. Recruiting Certain Types of Workers (use PP 2.21)
2. Recent undergraduates might be attracted to a tuition reimbursement benefit
4. Older workers might be attracted to stronger retirement plans
5. Tailoring packages might have unintended consequences, like
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D. Tax Incentives (use PP 2.22)
2. IRC allows companies to deduct some benefits as business expenses (more in chapter
3. IRC does not tax some benefits as income to employees
4. EXAMPLE: Employee at 25% tax rate. If company raises the employee’s salary by
5. Retirement plans are driven by generous tax treatments
E. Requirements to Make the Benefits Attractive
1. Employers need to figure out the cash value that employees place on particular
benefits
3. Employees have to be willing to give up wages/salary to receive benefits
VII. Who Pays for Benefits?
A. Employee or Employer (use PP 2.24)
1. Employees used to view benefits as “free add–ons”
2. Greatest portion of all employee benefits are paid by employees by
3. Company profits are seldom affected directly by higher benefits costs
B. Passing on Higher Costs Resulting in Lower Wages Depends on (use PP 2.24)
1. The cash value that employees place on the benefit.
a. EXAMPLE: Employees have 2 options; a $90,000 salary with no health
2. The degree to which employers will increase /decrease their hiring when the market
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a. EXAMPLE: If an employer wants to add a $10,000 (per employee per year)
health plan to employees salary of $100,000. Employers could assume the
3. Whether the benefit cost increases for all employers in the market, or for a specific
employer.
C. Reasons Why Health Insurance Costs Might Rise (use PP 2.25)
2. Legal changes allow doctors to unionize and thereby charge higher prices for the
3. Health insurance costs rose by 10% at only this employer because the company
4. Health insurance costs rose by 10% at only this employer because the employer
D. Indications
2. Employees believe that #2 & #4 do NOT add value to their insurance
4. #3 & #4 are specific to a particular employer, not the entire industry
6. When the increases are not seen as adding value to the insurance, employers may
7. The increases may NOT be passed along depending on
a. Whether the insurance costs rise for this particular employer or all employers
8. EXAMPLE: To hire a high quality lawyer a company would have to pay at least
$100,000. An employer might be able to pay $80,000 and offer a health insurance
9. If workers are willing to leave the workforce when compensation levels fall, and
Chapter 02 – The Psychology and Economics of Employee Benefits
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© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in
whole or part.
a. Especially for prime-age (30 to 54) male workers
b. NOT as common among women with children, the elderly, part-time
workers, and young workers
E. Who Pays
1. Most workers with employer-sponsored health insurance pay a token monthly
contribution towards their insurance premium
2. According to data from the 2011 National Compensation Survey
a. Most employees were required to make contribution make a contribution
toward their health insurance cost.
3. The monthly contributions allow employers to charge employees different rates,
5. Instead of lowering income employers may also
a. Scale back a scheduled bonus
Summary
This chapter discusses two important issues. First, psychological basis of employee benefits are
examined from the employee’s perspective. Employee benefits practices can fulfill employees’
transactional and relational expectations from the employer and employment exchange
relationship. If employees view their employer’s benefit program as fair and meeting their
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Discussion Questions
1. Discuss the concept of social exchange as it relates to the employment relationship. How does
this concept apply to employee-benefits practices?
2. Discuss how changes in the demographic composition of the U.S. workforce will affect the
employment relationship from an employer’s perspective. What possible impact will these
changes have on employee-benefits practices?
3. What are psychological contracts? Discuss the main features of psychological contracts and
how they develop.
Main Points
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• Toward the transactional end, employees’ expectations are more economic and extrinsic
in nature. On the other hand, toward the relational end, employees’ expectations might be
4. How do employee benefits form a part of employees’ psychological contracts? Discuss how
employees’ psychological contracts might be violated and the consequences of these violations
for employers.
Main Points
5. One reason employers offer benefits is that the benefits may be cheaper for the employers to
provide than it would be for the employees to purchase on their own. Besides the insurance
examples discussed in this chapter, what other benefits are cheaper for employers to provide than
for individuals to purchase on their own? Even if a particular benefit is cheaper for an employer
to provide, would that employer always want to provide it as part of a compensation package?
Why or why not?
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Main Points
• Student answers will vary.
6. One reason employers might offer a particular employee benefit is to aid in recruiting certain
types of workers. One example given in this chapter is a tuition reimbursement program to attract
highly motivated employees. What other examples of benefits are you familiar with that might
be used to attract a particular type of employee? What types of employees are most attracted to
these benefits?
7. Small employers are less likely than large employers to offer health insurance to their
employees. One reason for this is that health insurance tends to cost more for small employers
than for large employers. Explain why health insurance costs more for smaller insurance pools.
What public policies are currently being proposed to remedy the disparity in health insurance
coverage between small and large employers?
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8. A major theme of this chapter is that employers need to know the dollar value that employees
place on benefits. Explain concisely why this type of information is important for employers to
have. What methods do employers actually use to gauge their employees’ valuation of benefit
packages?
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Cases
Understanding Your Benefits
Forgoing a Benefits Package
1. Why would a company offer salary with no benefits?
2. Do you think the offer without benefits is worth pursuing?
Instructor Notes
Employers offer benefits to employees for many reasons. An employer is able to offer benefits
such as health insurance at a lower cost than if the employee would purchase the benefit on his or
Student Responses
1. Why would a company offer salary with no benefits?
2. Do you think the offer without benefits is worth pursuing?
Chapter 02 – The Psychology and Economics of Employee Benefits
Cutting Benefits at Generals Construction
1. Does Jane have a valid concern?
2. What kind of changes could the company make to benefits to address Jane’s
concerns?
Instructor Notes
When designing benefit plans, organizations are challenged to balance economic needs with the
expectations of employees. In this case, based on the psychological contract that the employees
have with the company, these cuts could make the employees feel that their expectations were
Student Responses
1. Does Jane have a valid concern?
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2. What kind of changes could the company make to benefits to address Jane’s
concerns?