INCOMPLETE INFORMATION, NON-WAGE BENEFITS AND DESIRABLE-WORKER SELF

SELECTION

ELIAICIM IUTZ

Bar-llarz University and

York University

ADRIAN ZIDERMAN

Bar-llan University

I The existence of non-wage benefits - both pecuniary and non-pecuniary - has been long

recognized in the economics literature; indeed, recognition that non-wage benefits must be included in the “net advantages” of a job goes back to Adam Smith. Yet, there has been very little work aimed at solving one particular puzzle that non-wage benefits pose: since workers may in general be expected to prefer to receive the wage equivalent of non-wage benefits from a job - since this enlarges their choice set - any employer paying part of the remuneration in the form of non-wage benefits would seem to be effecting a non Pareto optimal contract. One would then expect to observe a renegotiation of the contract converting the non-wage benefit into a wage benefit - to the mutual benefit of both sides. The puzzle therefore concerns the ongoing existence of non-wage benefits (whether of the fringe or non-penuniary variety) in many jobs.

It is our purpose in this paper to provide an approach to the above puzzle which views the non-wage element in the total benefits package as a major control instrument available to employers, in the absence of complete information about potential employees.

Let us set on one side some explanations we shall not be offering. Non-wage benefits. especially in the form of fringe benefits, may be preferred since by virtue of certain tax benefits they are Pareto efficient. Again, non-wage benefits may be offered where they have the characteristics of a public good and. hence, are more efficient than wages - for example, bettcr lighting or airconditioning in an office. Also. certain non-wage benefits may bc offered that may be considered by the employer to be conducive to greater employee efficiency. Within this category we may mention once again lighting and airconditioning. as well as free membership in health clubs, for example. Finally, non-wage benefits may be offered which are endogeneous to the job and cannot be separated from it (except. perhaps, at prohibitive cost). This category includes, for example. “prestige” derived froin certain positions or a healthy outdoor life derived from others.

In a recent contribution, Woodbury (1983) presents no less than seven major explanations for the increasing prevalence of fringe benefits in total remuneration in recent years (supplementing an earlier listing by Rice, 1966). By contrast, and the recent contri- bution of Atrostic (1982) notwithstanding, the issue of non-pecuniary benefits has received much less attention in the literature. Our own explanation for the inclusion of non-wage benefits in the remuneration package - which should be seen as complementary to, rather

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1986 NON-WAGE BENEFITS AND WORKER SELF SELECTION 253

than competitive with, existing approaches - applies equally well to both non-wage benefits of the non-pecuniary kind and to those in the form of fringe benefits. We suggest, in the discussion that follows, that the payment of non-wage benefits may arise on the initiative of the employer if he does not possess complete information on the desirability of individual workers. By using non-wage benefits. we show that he is able to attract to the firm, by a process of self-selection, workers with certain required worlc-related personal characteristics which are not initially identifiable.' Our basic reasoning is presented in the section that follows.

I1 The suitability of a person to a particular profession or job is likely to be multi-faceted. In

one job, a person might be required to show intelligence, initiative and commitment. In another, the requirements may be patience, caution and brawn. In order to facilitate a reasonably simple exposition of our theory, we shall assume that we are considering a job which requires two attributes only - one of which is measurable at some cost while the other is not measurable, except perhaps at a prohibitively high cost. To make these attributes tangible let us assume that the measurable attribute is intelligence and the non- measurable one is commitment. In addition, we assume that the two attributes are not, from the employer's perspective, substitutable, ie., the employer requires at least a given degree of intelligence and a certain amount of commitment.

In selecting his workforce, therefore, the employer is able to test for the intelligence of prospective employees but unable to test for their commitment. Hence, he must motivate prospective employees in two ways. Firstly, he must minimize the number of applications of insufficient intelligence so as to minimize his costs of testing. Secondly, he must try to ensure that applicants of a sufficient intelligence who are not committed, d o not apply, since he has no way of screening them out.

Consider now a given employment situation in which two types of benefits are available x 1 and x 2 ; let x2 be wage income and x 1 be a particular non-wage benefit. We assume committed workers to have a relatively stronger preference for x 1 than do uncommitted workers. It is this difference in the preferences between committed (more generally desirable) workers and uncommitted (more generally undesirable) workers that forms the core of our approach. Hence, some examples might be in order. People who are capable of long term commitment are more likely to have families and mortgages than people who are not capable of long term commitmcnts. Hence. x1 might be a family allowance. subsidized education or help with mortgage payments. If on the other hand the desired but unobserved characteristic is a high degree of risk aversion. then x1 might be subsidized insurance or pension schemes, cheap health care plans, and so on.

'It has been noted briefly in the recent text by Ehrenberg and Smith (1982) that fringe benefits may he used by employers to circumvent anti-discrimination laws. This explanation of fringe benefits is therefore in the same category as the tax benefits explanation in so far as it points a finger to govern- mental interference in the market as being ths sourceofnon-optimal orrangentments. I n contrast. o u r explanation of fringe benefits is general in not being dependent on governmental activity and would predict that fringe benefitsexist even in theabsence ofgovernment intcrfcrcnce -essenti;illy as devices aimed at reducing the impact of inforniation gaps.

254 AUSTRALIAN ECONOMIC PAPERS DECEMBER

Using the above idea we have in Figure 1, homothetic indifference curves I , and I, which relate to the preferences of committed and uncommitted workers, respectively * Furthermore, we assume that the minimal level of satisfaction required by a person of sufficient intelligence t o get the job is given by I , and I,, respectively for Committed and non committed workers Finally, the ratio of market prices of x 2 to x 1 is given by the slope of AB

Assuming that workers may purchase "1 without transaction costs, if the employer pays wages OA units of x 2 , he will attract applications from all committed individuals who require I, or less. Their equilibrium will be at points L on I , and F on i,. respectively ' Having tested all these individuals for intelligence, the employer will then be left with individuals, both committed and non-committed. of just the prerequisite intelligence Not surprisingly, since he has screened for intelligence only, the non-committed workers have not been excluded

FIGURE 1 x2

V

A

R

T

0

'Essentially we are assuming in figure 1 that for any pair ( X I . x 2 )

where Us (xl, x 2 ) and U , (xl. x2) are the utility functions of the desirable and undesirable workers respectively. and where U1 = (dU, /dx l ) clc.

'Given homothetically and the inequality in footnote 1 , desirable workers will choosex a n d ,~2,,a11d undesirable workers will choose x l t r and x l u and

S

such t h a t x i s > ~ 1 ~ ~ . "zS < ,~2[,.

1986 NON-WAGE BENEFITS AND WORKER SELF SELECTION 255

The following alternative strategy is now open to the employer. Let him offer to pay a remuneration package of OR units of wages ( x 2 ) and OD units of good X I . Assuming t h a t x l is not resaleable, the budget line now facing prospective employers is RLB. Clearly, therefore. committed individuals are in the same position as before - able to reach indifference curve is, if they possess sufficient intelligence. Non-committed individuals however are now able to reach only indifference curve 1; and thus will not apply. Even i fxl is resaleable but at a cost, a similar conclusion will apply since uncommitted workers though able to move to a n indifference curve above I ; , are unable to reach iu, given the slope ( G L ) of the effective price line of trading x1 for x2, left of point L. Using the intelli- gence screen, therefore, the employer will be left with only committed employees of suff- icient intelligence.

The employer can be seen to have reduced his intelligence screening costs by using this strategy, since all individuals who are both uncommitted and who require a minimum satisfaction greater than 1; will not apply.4 Thus, in addition to assuring himself of only committed workers the employer will have saved the cost of testing non-committed workers in the 1; - f, minimum satisfaction range.

This suggests that the employer may at times wish to go further and pay his employees only OTwage units and OC units of the xl. The budget line in this case is TNQ. Committed workers of sufficient intelligence are a t a level of satisfaction 7, as before. The whole 1;;::' - 7, range of non-committed group's potential applications will have been excluded and not, as in the previous strategy, just in the 1; - lu range.

Of course, this strategy implies a higher cost of the remuneration package to the employer, being worth OVunits of "2. Nonetheless, if the intelligence screen is sufficiently expensive and/or the utility derived from x 1 by uncommitted persons is sufficiently low (so that 1;':' - lu is a wide range) -this may be a profitable strategy for the employer to adopt. I f this strategy is indeed adopted, a non-Pareto optimal contract seems to have taken place, since committed workers would prefer for a remuneration package of the same value to move to point W on 1; (>is). Nonetheless, for the employer this may be a n optimal strategy. and hence, despite appearances to the contrary, the contract may be Pareto efficient, in the sense that the employer cannot improve the welfare of his einployees without harming himself.

111

The model presented in section I I offers a possiblc explanation for the inclusion within the total remuneration package of non-wage benefits; this explanation runs in terms of employers' attempts to elicit a positive self-selection of workers with required (or highly desirable) work related personal characteristics, in the absence of complete information about workers. The key element in our approach is the hypothesis that in various occupations or lines of work there exists a positive correlation between worlters' possession of various personal characteristics desirable to employers (initially unidentifiable except at high cost) and between these workers' tastes for particular types of non-wage benefits. Indeed. the reader should note, that our theory works only i f such a

256 AUSTRALIAN ECONOMIC PAPERS DECEMBER

correlatiori cxisrs. Sonic examples o f this correlation were given i n the previous section. I t is this correlation in the presence of appropriate non-wagc benefits that works to attract employees with desirable characteristics and dispel those M i t h undesir~hlc ones. Since o u r ciplanation of thc existence of non-wage benefits is not intended to be mutua11y exclusive of. but rather complementary to. existing approaches. we do not posit that such a correlation exists in all cases where nun-wage benefits are paid. However. i t is suggested that such a correlation is to bc found in a large range of employments. which serves as a lactor. additional to other c;1uscs, leading to an even greater percentage o f the benefit package being paid in the form of non-wage benefits. than would othcv-wise be the case

A particular application of this correlation, of some interest, may be drawn from the field of the public service professions such as teaching, social work and nursing, where the importance of maintaining quality of service combined with the difficulty of employer monitoring of quality of service provided by individual workers, renders all the more vital the task of attracting to these professions workers with a positive approach to the profession. Hence the total benefit package should ideally contain such elements that would appeal in particular to those with this sense of vocation, and aimed at enhancing their overall level of satisfaction and achievement. Such elements might include particularly favourable working facilities and conditions, opportunities in working time for updating professional knowledge. and so on. The availability of a high level of such non- wage benefits in the overall benefits package relating to these jobs would in particular tend to foster a process of self selection of potentially desirable workers, to enter the profession. Indeed such considerations may go some way towards answering the question: why frequently is there no effective response to labor shortages in various public sector service employments in the form of wage increases, sufficiently large to clear markets? A corollary of raising wages however is to attract to these professions persons placing a relatively high value on additional wages income and ii relatively low w<%ight on ol'fering public service: hence. wages may not be raised to high levels. in order to avoid attracting t o the profession workers with undesirable attitudes (and subsequently providing low quality of output on the job). That such shortages persist may be thc result ol'a failure to tormulatc~ an adequate total remuneration package. including appropriate non-wage bcwefits

REFERENCES

Atrostic, €3 I<. (1982). "The Demand for Leisure and Non-pecuniary Job Characteristics". Anrericari

Ehrenberg, Ronald G . and Smith. Robert S. (1982). .Modern Labor Economics. (Glenview: Illinois).

Rice. Robert G. (1966), .'Skill, Earnings and the Growth of Wage Supplements". Anrerican Eco/roriric

Woodbury, Stephen A. (1983). "Substitution Between Wage and Nonwage Rcncfits". American

Economic Review, June.

RezJiew Proceedings. May.

Economic Review. March