7 – 1 Compensation – Thirteenth Edition Gerhart │Newman │Milkovich
CHAPTER SEVEN
DEFINING COMPETITIVENESS
Overview
This begins Part Three – External Competitiveness: Determining the Pay Level, containing
Chapters Seven and Eight. 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
The key factors that influence external competitiveness are identified and discussed. These
factors include:
• Competition in the labor market for people with various skills
Next, the various competitive pay policy options that an organization can choose are explained.
These alternatives include:
• Pay above market (lead)
The chapter concludes by examining the consequences of an employer’s choice of a pay policy
Chapter Seven: Defining Competitiveness 7 – 2
on the objectives of the pay model—efficiency, fairness, and compliance.
Learning Objectives:
• Define external competitiveness and understand the two objectives of both pay-level and
pay-mix decisions.
• Identify the forces that shape external competitiveness; emphasizing the modifications to
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Lecture Outline: Overview of Major Topics
I. Compensation Strategy: External Competitiveness
A. Control Costs and Increase Revenues
B. Attract and Retain the Right Employees
II. What Shapes External Competitiveness?
III. Labor Market Factors
A. How Labor Markets Work
B. Labor Demand
C. Marginal Product
D. Marginal Revenue
E. Labor Supply
IV. Modifications to the Demand Side
A. Compensating Differentials
B. Efficiency Wage
C. Sorting and Signaling
V. Modifications to the Supply Side (Only Two More Theories to Go)
A. Reservation Wage
B. Human Capital
VI. Product Market Factors and Ability to Pay
A. Product Demand
B. Degree of Competition
C. A Different View: What Managers Say
D. Segmented Supplies of Labor and (Different) Going Rates
VII. Organization Factors
A. Industry and Technology
B. Employer Size
C. Organization Strategy
VIII. Relevant Markets
A. Defining the Relevant Market
B. Globalization of Relevant Labor Markets: Offshoring and Outsourcing
IX. Competitive Pay Policy Alternatives
A. What Difference Does the Pay-Level Policy Make?
Chapter Seven: Defining Competitiveness 7 – 4
Lecture Outline: Summary of Key Chapter Points
I. Compensation Strategy: External Competitiveness
• In Part Two, Internal Alignment, we looked at comparisons inside the organization. In
external competitiveness, the second pay policy, we look 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
• Both pay level and pay mix decisions focus on two objectives:
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.
• The higher the pay level relative to what competitors pay, the greater the
relative costs to provide similar products or services.
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two Japanese automakers in the U.S. and compares what the companies get in
return.
o As of 2007, U.S. automakers had higher labor costs, but lower reliability
and lower road test performance ratings on average.
o GM and Chrysler subsequently went through bankruptcy and it may be
inferred that the Big Three’s pay-level strategy has not worked for them.
• Exhibit 7.2 traces the history of two “legacy” airlines, USAir and American, and
relative newcomer, Southwest.
o As in the automobile industry, we can look at what employees cost and what
the airlines receive in return that would help drive revenues.
o American was the last major airline to go through bankruptcy, which
included a merger with USAir.
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
Chapter Seven: Defining Competitiveness 7 – 6
nonfinancial returns—more challenging and interesting projects, possibility of
international assignments, superior training, more rapid promotions, or even
greater job security.
o Different employers set different pay levels; that is, they deliberately choose
• 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:
• 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”.
o There is no single “going mix” of pay forms, either.
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.
III. Labor Market Factors
• Economists describe two basic types of markets:
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quoted price market.
o Bourse—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
A. How Labor Markets Work
• Theories of labor markets usually begin with four basic assumptions:
1. Employers always seek to maximize profits.
• 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.
o The demand side focuses on the actions of employers: how many new hires
• Exhibit 7.6 shows a simple illustration of demand and supply for business
school graduates at various salary levels.
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.
Chapter Seven: Defining Competitiveness 7 – 8
marginal product of labor.
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 (e.g., office space, number of computers, telephone lines,
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.
• Recall that the first labor market theory assumption is that employers seek to
maximize profits.
• Exhibit 7.7 shows the connection between the labor market and the conditions
facing a single employer.
o On 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
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• A manager using the marginal revenue product model must do only two things:
• The model provides a valuable analytical framework, but it oversimplifies the
real world.
• Neither the marginal product nor the marginal revenue is directly measurable.
o Managers do need some measure reflecting value.
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.
o As the assumptions change, so does the supply.
IV. Modifications to the Demand Side
• Economic models must frequently be revised to account for reality.
• When we change our focus from all the employers in an economy to a particular
employer, models must be modified to help us 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:
A. Compensating Differentials
Chapter Seven: Defining Competitiveness 7 – 10
• 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.”
B. Efficiency Wage
• According to efficiency–wage theory, high wages may increase efficiency and
actually lower labor costs if they:
o Attract higher-quality applicants.
• 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.
o One study looked at shirking behavior by examining employee discipline
and wages in several auto plants.
o Research shows that higher wages actually do attract more qualified
applicants.
o A study of hospitals found that those paying high wages to staff nurses
employed fewer nurse supervisors.
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▪ The researchers did not speculate on whether the higher wages attracted
better nurses or caused average nurses to work harder.
▪ They also did not say whether the hospital was able to reduce its overall
nursing costs.
• 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.
• 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
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.
• An employer that combines lower base pay with high bonuses may be signaling
that it wants employees who are risk takers.
• Check out Exhibit 7.4 again.
o The pay mix at company A emphasizes base pay (84%) more than does the
mix at company B (64%) or the market average (67%).
• A study of college students approaching graduation found that both pay level
and mix affected their job decisions.
o Students wanted jobs that offered high pay, but they also showed a
preference for individual-based (rather than team-based) pay, fixed (rather
Chapter Seven: Defining Competitiveness 7 – 12
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than variable) pay, job-based (rather than skill-based) pay, and flexible
benefits.
o Applicants appear to select among job opportunities based on the perceived
match between their personal dispositions and the nature of the organization,
as signaled by the pay system.
o Both pay level and pay mix send a signal, which results in sorting effects –
who joins and who stays with the organization.
• Signaling works on the supply side of the model, too, as suppliers of labor
signal to potential employers.
o People who are better trained, have higher grades in relevant courses, and/or
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
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.
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investment increases, thereby creating an upward-sloping supply.
• A number of additional factors affect the supply of labor.
o Geographic barriers to mobility among jobs.
• Nonmonetary aspects of jobs (e.g., time flexibility) may also be important
aspects of the return on investment.
VI. Product Market Factors and Ability to Pay
• The supply and demand for labor are major determinants of an employer’s pay level.
• However, any organization must, over time, generate enough revenue to cover
expenses, including compensation.
o It follows that an employer’s pay level is constrained by its ability to compete in the
• The two key product market factors that affect the ability of an organization to change
what it charges for its products and services are:
A. Product Demand
• Although labor market conditions (and legal requirements) put a floor on the
pay level required to attract sufficient employees, the product market puts a lid
on the maximum pay level that an employer can set.
B. Degree of Competition
• Employers in highly competitive markets, such as manufacturers of automobiles
or generic drugs, are less able to raise prices without loss of revenues.
• Other factors besides product market conditions affect pay level and
compensation decisions.
o The productivity of labor.
Chapter Seven: Defining Competitiveness 7 – 14
C. A Different View: What Managers Say
• Discussions with managers provide insight into how all of the economic factors
translate into actual pay decisions.
• In one study, a number of scenarios were presented in which unemployment,
profitability, and labor market conditions varied. Managers were asked to make
wage adjustment recommendations for several positions.
o Level of unemployment made almost no difference.
• In recent times, the unemployment rate is higher than it has been in two decades
and companies are indeed making pay cuts, either outright or by requiring
employees to take days off (often called furloughs) without pay.
D. Segmented Supplies of Labor and (Different) Going Rates
• One option to reduce labor costs is segmenting the source of labor.
People Flow to the Work
o Consider how a hospital staffs and pays its nursing positions and what each
method costs.
▪ The number of nurses the hospital needs on each shift depends on the
number of patients.
▪ To deal with fluctuating patient numbers, the hospital uses four different
Work Flows to the People—On-site, Off-site, Offshore
o Apriso, a California company, designs and installs computer-assisted
manufacturing software used in factories around the world.
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▪ Apriso can staff the project with employees who are on-site, off-site, or
off-shore.
▪ It can “mix and match” its people from different sources.
o Which source Apriso includes in its bid depends on many factors:
▪ customer preferences,
▪ time schedules, and
▪ the nature of the project.
• There are three points (“so whats?”) to remember from this discussion:
o Reality is complex and theories abstract. The theories discussed simply
abstract away the detail, clarifying the underlying factors that help us
understand how reality works.
VII. Organization Factors
A. Industry and Technology
• The industry in which an organization competes influences the technologies used.
• Labor-intensive industries (education and health care) tend to pay lower than
technology-intensive industries (petroleum or pharmaceuticals), whereas
B. Employer Size
• There is consistent evidence that large organizations tend to pay more than small
ones.
• The relationship between organization size, ability to pay, and pay level is
C. People’s Preferences
Chapter Seven: Defining Competitiveness 7 – 16
• Better understanding of employee preferences of pay forms is increasingly
important in determining external competitiveness.
D. Organization Strategy
• A variety of pay-level and mix strategies exist.
o Some employers adopt a low-wage, no-service strategy; they compete by
producing goods and services with the lowest total compensation possible.
▪ Nike and Reebok both rely heavily on outsourcing manufacturing to
countries with lower labor costs.
o Others select a low-wage, high-services strategy.
▪ Marriott offers its low-wage room cleaners a hotline to social workers who
o Still other employers use a high-wage, high-services approach.
▪ Medtronic’s “fully present at work” approach, discussed in Chapter 2, is
an example of high wage, high services.
• One study found that, like the company in Exhibit 7.3, a variety of pay-level
strategies exist within some organizations.
o Pay levels that lead competition are used in jobs that most directly impact the
• Efficiency wage argues that some firms, for a variety of reasons do indeed have
efficiency reasons to pay higher wages.
o Higher pay levels, either for the organization as a whole or for critical jobs, may
be well-suited to particular strategies, such as higher value-added customer
segments.
• Evidence suggests that organizations making greater use of so-called high-
performance work practices (teams, quality circles, total quality management, job
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quality, and/or innovation).
o Otherwise, a firm’s ability to compete and survive is in question.
• Evidence shows that in manufacturing, productivity (defined as sales value of
VIII. Relevant Markets
• Although the notion of a single homogeneous labor market may be a useful analytical
device, each organization operates in many labor markets, each with unique demand
and supply.
o Some face segmented supplies for the same skills in the same market – hospitals.
o Others think more broadly about which markets to use as sources of talent – Apriso.
They seek to answer the question: What is the right pay to get the right people to do
the right things?
• Consequently, managers must define the markets that are relevant for pay purposes and
establish the appropriate competitive positions in these markets.
• The three factors usually used to determine the relevant labor markets are:
A. Defining the Relevant Market
• Little research has been done on how employers choose their relevant markets.
• Two studies do shed some light on this issue:
o They conclude that managers look at both competitors—their products,
• The data from product market competitors (as opposed to labor market
competitors) are likely to receive more weight when:
1. Employee skills are specific to the product market. (Recall the differences
in Boeing millwrights versus GE locomotive millwrights.)
Chapter Seven: Defining Competitiveness 7 – 18
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low, everyone who wants to work is working. Pay does not change that.)
B. Globalization of Relevant Labor Markets: Offshoring and Outsourcing
• Work flowing to lower wage locations is not new. Clothing and furniture jobs
flowed from New England to southern states.
• Nor is work flowing across national borders new.
o First, it was low-skill and low-wage jobs from the U.S. to China and Central
• Vastly improved communication and software connectivity have accelerated
these trends.
• In Chapter 4, we discussed characteristics of jobs that are thought to increase
susceptibility to offshoring:
o Easily routinized
• IBM pays a computer programmer with three to five years of experience $56
per hour in total compensation.
o In China, a similar qualified programmer cost $12.50 per hour.
• Offshoring is also happening to lawyers and financial services jobs.
o Lawyers charging $75 to $100 an hour in India are doing legal work for
Wall Street banks, rather than paying U.S. lawyers $200 an hour.
• While large differences in labor costs cannot simply be ignored, there are other
factors to consider in deciding where jobs will be.
o As we saw in Chapter 1, countries with lower average labor costs also tend
o There may be other risks.