How Companies Decide What To Pay Their Workers

Determining salaries in many cases is much more of an art than a science. Performance bonuses, salary ranges and wage increases can be difficult territory for both employers and employees.

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STEVE INSKEEP, host:

And David, our Planet Money team has been thinking about employee compensation. You may wonder about it yourself. Why do I get paid less than the guy over there? Or maybe, why do I get paid more than this person over here? What are the basic economic theories here, if any? NPR's Chana Joffe-Walt looked into it.

CHANA JOFFE-WALT: For a waitress, it depends how generous your customers are. For a paramedic, it has more to do with whether you work for a public or private organization than how many lives you save. For a male model, it has to do with how hot you are - although no matter how hot you are, you will not make as much as a female model. And for guys in Raymond McCormick's mechanics shop in Southern California, it is whatever the book says.

Mr. RAYMOND MCCORMICK (McCormick Diesel and Brake): Well, we have this real big, thick red book called a time guide or a labor guide. And it says that on such and such a vehicle, it should only take one and a half hours to do this brake job.

JOFFE-WALT: Do you have the book right there?

Mr. MCCORMICK: Sure. Hold on a second. Let me walk across the room and get it. Just a moment. Here we go. Nice and big.

JOFFE-WALT: If the mechanic gets the job done in 45 minutes, kudos to him. He still gets paid for an hour and a half. If it takes him five hours, too bad. This is probably not how you get paid. There is no standard. You would think with something as important as our income, there'd be some logic everyone would follow. No. There is a very basic economic theory about how employees should get paid. Economist Robert Frank explains.

Professor ROBERT FRANK (Economist): Each worker will be paid the market value of what he or she produces for the employer.

JOFFE-WALT: So the value that the employee adds to the employer is bottom line.

Prof. FRANK: Exactly.

JOFFE-WALT: So does that happen?

Prof. FRANK: Well, no.

JOFFE-WALT: An economic theory that is logically sound but totally doesn't explain the real world. In your office, business, wherever you head into work, here's probably what happens. The people who are most productive, they get paid a little more than the least productive people, but not a lot more. How come? Here's a couple ideas.

Number one: It seems fair. You're all accountants; you all should make about the same amount. Although if you're the best accountant on your team, that might not seem so fair to you, which brings us to another possible explanation.

Prof. FRANK: If you ask somebody, how good are you? The typical factory worker will say, I'm in the 90th percentile in terms of productivity, vis-a-vis my colleagues. If you ask college professors, how good are you? Ninety-four percent of them will say they're better than their average colleague. If you ask drivers, how good a driver are you? More than 90 percent will say they're an above-average driver. There's a great study showing that drivers in the hospital recovering from accidents they'd caused, 85 percent of them thought they were above average.

JOFFE-WALT: What?

Prof. FRANK: Yeah. Oh, it was bad luck. So if everybody thinks he's above average and you do merit pay, and the merit pay is based on a fair assessment of how good you actually areā€¦

JOFFE-WALT: Then you've got half your employees getting below-average raises when 90 percent of them believe they're awesome. One more reason pay isn't always directly tied to performance: Performance can be hard to measure. If you manage a team of people collaborating on, say, a piece of software, it's not so easy to tell who's the most productive and who's the least.

In sales and finance and real estate, it's easier. That's the closest that we get to pure performance pay. Rachel Nelson is a Realtor in St. Paul. Her job is to sell homes. If she sells a lot, she adds to the company's bottom line, she makes a lot. If she doesn't, she makes less.

Ms. RACHEL NELSON (Realtor): You know, some years I can be making well into the six figures and other years, you know, I'm 40,000, or whatever. Or the person sitting in the desk next to you can be making five times what you're making. It seems like a fair system to me.

JOFFE-WALT: When we hear about executive bonuses on Wall Street, we get real angry. We get angry because of the enormous figures and because we handed these companies billions in bailout funds, but also because this isn't our experience of the world. Most of us don't get paid directly for good performance - not to mention that those bonuses don't exactly seem to reward good performance.

So if, in the regular world, the best people don't get paid a lot more than the worst people and our bonuses are not tied to sales or anything easily measurable, we should all slack off. Well, the most, most common way people increase their pay is through promotions. So work at least hard and long enough to get into the right position, and then you can slack off.

Chana Joffe-Walt, NPR News.

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