Defining External Competitiveness

External Competitiveness
- External competitiveness refers to the pay relationships among organizations.
- Achieved by setting a pay level and determining the mix of pay forms relative to
competitors.
- External competitiveness refers to the pay relationships among organizations—the
organization’s pay relative to its competitors. It also includes choosing the mix of pay
forms (i.e., bonuses, stock options, flexible benefits) that is right for the business strategy.
It is expressed in practice by (1) setting a pay level that is above, below, or equal to
competitors’ and (2) by considering the mix of pay forms relative to those of
competitors.
- LABOUR MARKET FACTORS
o Nature of Demand
o Nature of Supply
- Economic theories of labour markets usually begin with four basic assumptions:
o Employers always seek to maximize profits.
o People are homogeneous and therefore interchangeable; for example, a business
school graduate is a business school graduate is a business school graduate.
o The pay rates reflect all costs associated with employment (base wage, bonuses,
holidays, benefits, even training).
o The markets faced by employers are competitive, so there is no advantage for a
single employer to pay above or below the market rate.
- PRODUCT MARKET FACTORS
o Level of Product Demand
o Degree of Competition
 The productivity of labour, the technology employed, the level of
production relative to plant capacity available all affect compensation
decisions. These factors vary more across than within industries.
- ORGANIZATIONAL FACTORS
o Industry and Technology
 Differences in technology across industries, the introduction of new
technology within an industry also influences pay levels. For example, the
use of universal product codes, scanners, scales built into the counter, and
self-checkout lanes has reduced the skills required of cashiers. As a result,
their average pay has declined over time.
o Employer Size
o Employees’ Preferences
 People put more importance on pay than they are willing to admit.
o Organization’s Strategy
 Some employers adopt a low-wage, no-services strategy; they compete by
producing goods and services with as little total compensation as possible.
 Higher pay levels, either for the whole organization or only for critical
jobs, may be well suited to strategies, such as higher value-added
customer segments. Similarly, evidence suggests that organizations
 making greater use of high-performance work practices (such as teams,
quality circles, total quality management, job rotation) and having higher-
skilled workers also pay higher wages.

Labour Demand
- In the short term, an employer cannot change any other factor of production (e.g.,
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 labour coincides with its marginal product of labour.

Pay Level and Pay Mix

- Pay level refers to the average of the array of pay rates paid by an employer.
- Pay mix refers to various types of payments that make up total compensation.
- Pay level and pay mix decisions focus on controlling costs, increasing revenues, and
attracting/retaining employees.
- Factors that affect a company’s decisions on pay level and pay forms. The factors are (1)
competition in the labour market for people with various skills; (2) competition in the
product and service markets, which affects the financial condition of the organization;
and (3) characteristics unique to each organization and its employees, such as its business
strategy, technology, and the productivity and experience of its workforce. These factors
act in concert to influence pay level and pay forms decisions.

Pay Decisions
- Pay decisions impact labor costs and the organization's ability to attract and retain talent.
o Labor costs = Number of Employees x Pay Level
- The higher the pay level relative to what competitors pay, the greater the relative costs to
provide similar products or services.

How Labour Markets Work

- Theories of labor markets are based on four assumptions: employers seek to maximize
profits, people are interchangeable, pay rates reflect all employment costs, and markets
are competitive.

Labor Supply Analysis

- The model assumes many people are seeking jobs, possess accurate information about
job openings, and there are no barriers to mobility.
- Assumptions about potential employees' behavior are oversimplified.

Labor Demand Analysis

- Analysis of labor demand indicates how many employees will be hired by an employer.
- In the short run, an employer can only change the level of human resources to change
production.
- Demand for labor coincides with the marginal product of labor.

Marginal Product
 - Diminishing marginal productivity occurs when each additional employee has a smaller
share of production factors to work with
- Each new hire produces less than the previous hire, and the amount each hire produces is
the marginal product.

Marginal Product of Labour

- The marginal product of labour is the additional output associated with the employment
of one additional person, with the other factors of production held constant. The marginal
product of labour decreases as number of new hires increases.
- In the short term, factors of production such as office space, level of clerical support, etc.
are fixed. Until these factors of production are changed, each additional new hire
produces less than the previous hire.

Marginal Revenue
- Employers hire until marginal revenue equals the costs associated with the most recent
hire.
- The level of demand that maximizes profits is where marginal revenue equals the wage
rate.
- The model oversimplifies the concept of marginal revenue of labor.
Marginal Revenue of Labour
- The marginal revenue of labour is the money generated by the sale of the marginal
product—the additional output from the employment of one additional person.
- Determine the pay level set by market forces and (2) determine the marginal revenue
generated by each new hire.

Modifications to the Demand Side

- Compensating Differentials
o Work with negative characteristics requires higher pay to attract/retain workers.
o Job evaluation and compensable factors must capture these negative
characteristics.
- Efficiency Wage
o Above-market wages may improve efficiency by attracting workers with higher
abilities, by discouraging shirking/ quits, and may require less supervision.
o Staffing programs must be able to select the best employees; work must be
structured to take advantage of employees’ greater abilities.
- Signaling
o Pay policies signal to applicants the kinds of attributes/behaviours the employer
seeks.
o Pay practices must recognize desired behaviours with higher pay, larger bonuses,
and other forms of compensation.

Compensating Differentials
- If a job has negative characteristics, employers must offer higher wages.
- Job evaluation and compensable factors must capture these negative characteristics.
- If a job has negative characteristics, that is, if the necessary training is very expensive
(medical school, law school), job security is tenuous (stockbrokers, CEOs), working
 conditions are disagreeable (highway construction, garbage collectors), or the chances of
success are low (professional sports—NBA, NFL, MLB, etc.), then employers must offer
higher wages to compensate for these negative features.

Efficiency Wage
- High wages may increase efficiency and lower labor costs.
- Pay level determines effort, attracts higher-quality applicants, lowers turnover, increases
worker effort, reduces "shirking," and reduces the need for supervision.
- Higher the wage rate, the less likely it is that an employee would be able to find another
job that pays as well. Thus, overall turnover is expected to be lower. The higher wages
also motivate current employees to work harder and/or smarter. The underlying
assumption is that pay level helps determine the level of effort.

Signaling
- Employers design pay levels and mix to signal the kinds of behaviors they seek.
- Employee signals include better training, education, and work experience.
- Signalling theory holds that employers deliberately design pay levels and pay forms as
part of a strategy that signals to both prospective and current employees what kinds of
behaviours 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 who combines lower base with high bonuses may be signalling that it wants
employees who are risk-takers. Its pay policy helps communicate expectations.

Modifications to the Supply Side

- Reservation Wage
o Job seekers will not accept jobs if pay is below a certain wage, no matter how
attractive other job aspects are.
o Pay level will affect ability to recruit.
o Pay must meet some minimum level.
- Human Capital
o General and specific skills require an investment in human capital. The value of
an individual’s skills and abilities is a function of the time and expense required to
acquire them.
o Pay level needs to be high enough to offer sufficient return on investment for
workers to attain these skills.

Organizational Factors
- Labor-intensive industries tend to pay lower than technology-intensive industries.
- New technology within industry influences pays levels.
- Large organizations tend to pay more than small ones.
- Understanding employee preferences of pay forms is important in determining external
competitiveness.
- A variety of pay-level and pay-mix strategies exist, higher pay levels may be suited to
strategies.
Product Market Factors & Ability to Pay
- Product market conditions determine what an organization can afford to pay.
- Product demand and degree of competition are key factors.
- Other factors include the productivity of labor, technology employed, and level of
production relative to capacity.
- It follows that an employer’s pay level is constrained by its ability to compete in the
product/service market. So, product market conditions largely determine what the
organization can afford to pay. Product demand and the degree of competition are the two
key product market factors. Both affect the ability of the organization to change what it
charges for its products and services. If prices cannot be changed without decreasing
sales, then the ability of the employer to set a higher pay level is constrained.

Product Demand
- Although labour market conditions (and legal requirements) put a floor on the pay level
required to attract sufficient employees, the product market puts a ceiling on the
maximum pay level that an employer can set. If the employer pays above the maximum,
it must either pass on the higher pay level to consumers through price increases or hold
prices fixed and allocate a greater share of total revenues to cover labour costs.

Relevant Markets
- Three factors determine relevant labor markets: occupation, geography, and competitors.
- Data from product market competitors receive greater weight when employee skills are
specific to the product market, labor costs are a large share of total costs, and product
demand is responsive to price changes.
- If the markets are incorrectly defined, the estimates of competitors’ pay rates will be
incorrect and the pay level and mix of pay forms inappropriately established.
- The data from product market competitors (as opposed to labour market competitors) are
likely to receive greater weight when.
o Employee skills are specific to the product market.
o Labour costs are a large share of total costs.
o Product demand is responsive to price changes; and
o The supply of labour is not responsive to changes in pay.

Competitive Pay Policy Alternatives

- Three conventional pay-level policies: lead, meet, and lag.
- Competitiveness of pay affects the organization's ability to achieve compensation
objectives and employee performance.
- The basic premise is that the competitiveness of pay will affect the organization’s ability
to achieve its compensation objectives, which in turn will affect the organization’s
performance.

Pay with Competition (Match)

- The most common policy is to match rates paid by competitors.
- A match policy ensures the employer's ability to attract applicants will be equal to its
labor market competitors.
 - lead, or lag, the most common policy is to match rates paid by competitors.30 Managers
historically justify this policy by saying that failure to match competitors’ rates would
cause dissatisfaction among present employees and limit the organization’s ability to
recruit.
- A match policy tries to ensure that an organization’s wage costs are approximately equal
to those of its product competitors and that its ability to attract applicants will be
approximately equal to that of its labour market competitors.

Lead Pay-Level Policy

- Maximizes the ability to attract and retain quality employees. minimizes employee
dissatisfaction with pay. It may also offset less attractive features of the work.
- Higher wages ease attraction, reduce turnover and absenteeism, and result in better-
quality employees.
- Negative effects include the need to increase wages of current employees and masking
negative job attributes that contribute to high turnover later on (e.g., lack of challenging
assignments or hostile colleagues).

Lag Pay-Level Policy

- Paying below market rates may hinder the organization's ability to attract potential
employees unless coupled with higher future returns.
- If pay level is lagged in return for the promise of higher future returns (e.g., stock
ownership in a high-tech start-up firm), such a promise may increase employee
commitment and foster teamwork, which may increase productivity.
- Lagging on pay-level but leading on other work returns is possible.
- Unmet expectations can have negative effects.
- It is possible to lag competition on pay level but to lead on other returns from work (e.g.,
meaningful work, desirable location, outstanding colleagues, cool tools, work/life
balance).

Different Policies for Different Employee Groups

- Employers may vary the pay-level policy for different occupational families, forms of
pay, and business units facing different competitive conditions.
- Many employers go beyond a single choice among the three policy options. They may
vary the policy for different occupational families. Or they may vary the policy for
different forms of pay. They may also adapt different policies for different business units
that face very different competitive conditions.

Employer of Choice/Shared Choice

- "Employer of choice" corresponds to the brand the company projects as an employer.
- Shared choice offers employees choices in the pay mix.
- Risks include employees making "wrong" choices and offering too many choices leading
to confusion and dissatisfaction.

From Pitfalls of Pies

- Thinking about the mix of pay forms as pieces in a pie chart has limitations, especially
when the value of stock is volatile.
To the Dashboard
- Some companies prefer to report the mix using a "dashboard" that compares each
component to the market.
- The mix employees receive differs at different levels in the internal job structure.
- Greater emphasis on performance at higher levels is common practice among
organizations.
- The dashboard changes the focus from emphasizing the relative importance of each form
within a single company to comparing each form by itself to the market (many
companies).

Consequences of Pay-Level & Pay-Mix Decisions

- Efficiency
o No research suggests under what circumstances managers should choose which
pay-mix.
o Pay level may not be a source of competitive advantage.
o Wrong pay level may be a serious disadvantage.
- Fairness
o Satisfaction with pay is directly related to pay level.
o Sense of fairness is related to how others are paid.
- Compliance
o Employers must pay at or above the legal minimum wage.
o Prevailing wage laws, equal rights, and other legislation must be met.
- External competitiveness has two major consequences: it affects (1) operating expenses
and (2) employee attitudes and work behaviours.
- Some consequences of an Effective Externally Competitive Pay Policy
o Competitiveness of Total Compensation
 Reduce pay-related work stoppages.
 Increase probability of union-free status
 Reduce voluntary turnover.
 Increase quality and experience.
 Increase pool of qualified applicants
 Contain operating expenses (labour costs)