Bryan Caplan  

Merit-Based Pay Cuts: Why Not?

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Many universities now have pay freezes or even nominal pay cuts.  Under the circumstances, several professors have told me that there's little point in doing faculty evaluations.  If there's zero - or negative - money for raises, why bother saying who's doing well and who's not?

It amazes me how much these remarks take for granted.  Suppose a department is 5% over-budget.  It may be obvious that it needs to cut total compensation by 5%, but it isn't obvious that any particular professor's salary needs to be cut by 5%.  If raises can depend on performance, so can cuts!  If a chairman normally gives a 0% raise to his worst performer, and a 5% raise to his best performer, why not respond to fiscal austerity by simply changing the range from -7.5% to -.2.5%?

I guess you might say that professors resent equal pay cuts less.  But I doubt that.  Yes, under-achievers resent them more, but they frankly don't contribute much even when their morale is high.  And I bet that over-achievers would feel a lot better about pay cuts if they know that their good performance was still rewarded at the margin.

If there's any good argument against merit-based pay cuts, I can't think of it.  Anyone?

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COMMENTS (18 to date)
Jon Leonard writes:

They're usually called "reduced bonuses". In an environment where rewarding performance matters significantly, bonuses are usually part of the pay structure, and they do tend to get reduced during tough times.

That's mostly a psychological difference, though being able to budget for a minimum expected salary does have some purely economic value.

Nick writes:

Increased probability of employees "going postal."

anon9800 writes:

With cuts, when it is across the board, there is share sacrifice. We're all taking one for the team.

There's also probably a sense that we (the firm) have less money because of some external factors than had nothing to do with our individual performances. So those random, external losses should be shared by all, because it wasn't really attributable to anyone's performance. With gains, there's a sense that, even if someone got a bigger raise than someone else, perhaps that individual made the whole firm better off by going out and capturing that gain in the ether. With the loss, it might be hard to understand what an individual has done to deserve taking a smaller loss when these losses are perceived to be a random, external loss.

Bottom line, because of risk aversion, we respond more negatively to losses than gains.

DG writes:

Other than the points already in the comments... This actually would work best with the difference being substantial... like the winner gets a 1% cut and the loser gets a 7.5% cut... The 1% cut for the winner makes it easier to give a higher cut to the loser... and doesnt hurt the winner too much and he is happier looking at the difference...

agnostic writes:

Last-period problem. (Nick hit on this without knowing it.)

The people who make an academic department work all operate within a firm, rather than each one contracting with the other in a free market. The open-ended relationship between firm members helps to prevent the last-period problem, whereby individuals contracting through a free market have an incentive to shirk or otherwise behave opportunistically in the period just before the contract is due to close.

Clearly there is no predictable last period for people working in a firm. By the time you know the relationship is over, you don't have time to plan any opportunistic behavior -- the boss tells you to pack your stuff, and that's it.

Back to the academic department. In good times, professors, secretaries, etc., assume that their relationship will continue -- times are good, after all. They accept differential raises because they realize that some are more productive than others.

However, put yourself in the mind of someone who is told:

1) Things are going horribly bad for the firm, and look to stay that way for awhile.

2) Your pay will be cut by even more than others' pay.

Now, you are *much* less certain that your relationship with the firm will continue. It sounds like the firm may go belly-up soon. That brings the prospect of foreseeable last period to the foreground.

Moreover, even if the firm survives, it sure sounds like they're getting ready to escalate things if necessary and give you the ax. This is like the boss giving a worker a pink slip 2 months in advance -- lots of time to act opportunistically.

You can't avoid raising the probability of opportunism when you tell the workers that things are going bad for the firm. You'll just have to hope that this news isn't so bad to them.

But by giving differential pay cuts, you raise the probability much more for those who are on the low end.

And just the thought of merit-based pay cuts sounds like you're now in a ruthlessly calculating free market mindset, not an ongoing big happy firm mindset. That's how the workers will interpret it anyway. Note that this would raise the probability of opportunism *even for the high-performers* -- true, they aren't being dinged as badly as the other guys, but they now infer a change in the relationship from firm to free market (and when times are bad for the buyer, no less!), and accordingly re-adjust the perceived cost of opportunism -- lower now, so they're more likely to do it.

Anyway, key idea is that it's related to the last-period problem. That allows for an asymmetry between raises during good times (last-period problem doesn't exist) and cuts during bad times (last-period problem rears its head).

chris writes:

If academics are status-obsessed, mightn't the knowledge that others are getting bigger cuts than them actually improve morale? (depending upon the skewness of the cuts, among other things)
This cartoon is apposite:

wd40 writes:

Think of academics as being paid piece rate. Person A is twice as productive as person B and therefore is paid twice as much. Then demand for the product falls and the amount paid per piece is cut 10%. This is equivalent to a 10% across the board pay cut. Relative productivity has not changed.

geckonomist writes:

Because there is no way you can objectively calculate the merit or productivity of a professor.

Talk to the inventor of the laser. All his collegues and the academic world were making fun of him and his "useless" invention. Probably he deserved a pay cut according to Mr. Caplan, wasting valuable academic time like that.

Furthermore, if one has to cooperate (in such arbitrary environment) with other people on many projects, and one gets a pay cut and another one doesn't for whatever reason, the former shall make sure to sabotage the latter and such that the latter's performance is terrible in the next reporting period.
And don't forget, 75% of employees believe they belong to the "best" 25%. You'll create a majority of frustrated academic staff, angry and willing to sabotage "the winners".

and merit based pay, is it really so desirable?
Bankers seem to have been paid on a "merit" basis.
Can you explain me the benefit this banking concept brought to society?

ajb writes:

Except for those arguing for psychological asymmetries, most simply attack the idea of merit pay. But Bryan is asking you to assume differential merit pay because that is already the system in place. So even if you think merit pay is undesirable, it is already being used. Furthermore, the worst profs have tenure and are the most immobile since no one else wants to hire them [untenured ones will just get fired in a few years]. Given all that, why not apply the same logic for cuts that is applied every normal year for pay raises?

Carl The EconGuy writes:

Academic productivity cannot be objectively measured, it's subjective. If tried, it would be a weighted average of a bunch of hedonic metrics cobbled together by academic administrators. Pretty useless, in other words, and open to interminable law suits.
Better to use the opportunity cost approach. Lower the salary of everyone until they are on the margin of staying or leaving. Let the market decide salaries, in other words. We'll give you an offer of what we are prepared to pay, take it or leave for employment elsewhere or for retirement.
In other words, suck out the rents with a market based salary approach that does not rely on subjective productivity metrics.

forager writes:

I think a lot of the detractors could be convinced by thinking of this in a different way:

First, every employee gets a 10% pay cut effective immediately. The employees who perform best get an ~11% pay raise, the medium performers get a ~5.6% pay raise, and the worst performers don't get any pay raise. In the end, this arrangement is equivalent to the best employees getting their original salary, the medium performers getting a 5% pay cut, and the worst getting a 10% pay cut.

Psychological manipulation at its best.

ajb writes:

Carl the econ guy seems to ignore the ideas of Williamson -- this year's Nobelist. Because of asset specificity, sucking out all the rents would be a kind of ex post opportunism on the part of universities, undermining their appeal to workers. Part of tenure and sticky wage contracts is exactly to encourage some risk taking and production of ideas that may not be valued in the short term market of fashionable publications.

Yancey Ward writes:

Nothing wrong with it at all. Happens in the private, non-academic sector all the time in which the least productive are the first to be laid off.

Scott Wentland writes:

You can look at it from an imperfect information perspective or coordination one.

Information: When accepting a tenure track position, I will probably be uncertain about the value and variance of my future output. Having no (or few) paycuts is kind of like insurance for my unproductive years. Think of the Econ Department as a law firm or something like that, which doesn’t pay piecemeal because of the variance of output.

Coordination: if GMU does paycuts, and other schools don’t, then GMU will likely lose out on desirable job candidates (who may be risk-averse). I would think that competition is a decent check on paycuts…maybe the reason why they don’t do it (rational or not) is because the competition doesn’t do it (because quality risk-averse professor will flock to those schools).

Philo writes:

The academic tradition of tenure implicitly requires at least severe limits on differential pay-cutting. What is the value of having a safe job if your pay can be cut by any amount? Of course, tenure may be a bad system, on the whole; but there *are* some considerations in its favor.

manuelg writes:

Against my advice to fire this employee, a manager I know tried cutting the salary of this hire who plainly overstated his qualifications.

On top of overstated qualifications, this employee was already giving only 60% of full effort.

I predicted that his poor motivation would become even worse after the pay cut, and that he would become a "dead man walking".

I was right. He sank to giving 25% of full effort. He had to be fired a few weeks later.

Paid wages and salaries are already known to make people behave irrationally. I cannot find the exact quote, but I remember Frank Zappa saying "The quickest way to make somebody hate you is to pay them a salary". People need money, but they hate having their worth explicitly quantified. Any jockeying of their pay-rate runs the risk of bruising their ego and shattering their motivation - again, going against their rational need for the paycheck.

I would recommend immediately firing any employee that puts their own ego before a paycheck that feeds their own family, and or puts their own ego before serving the customer that makes their paycheck possible. No possible good can come from that employee, over time.

Maddog writes:

In a productive enterprise it makes no sense to alter the top portion of the pay package. If before the problem an individual would have been entitled to a 5% raise that should remain the same even in light of the need for the department to lower costs by 5%. A crafty employer could reconfigure this as a bonus to avoid the worry of pay inflation (see below).

How much more valuable is the salesperson who exceeds goals during times of economic difficulty? Cutting these employees pay is like suicide by a thousand cuts. Other employers will seek out and pay these persons what they are worth. How many of these can the department lose before it dies of blood loss?

The dead weight should receive pay cuts according to their value to the department. This might be zero to 10% or even 20% reductions. Do you really care if the poorest performers leave to work for a competitor? I think not.

But since academics are generally not productive under any analysis, I have no idea how to compensate them at all. Best looking? Biggest smile? Best tweed jacket? Best "gun" rack? Most ideologically pure? I suspect purity wins out here.

Since we are seeing deflation in pay right now it seems optimal to spike raises altogether and opt for bonus instead. And yes the bonus could be negative for the dead wood. This way the department is not saddled next year with the specter of ever inflating wages while generally wages are declining. Next step would be real pay cuts if the situation did not improve.

The title “Merit-Based Pay Cuts: Why Not?” likewise requires pay increases if merited or why bother with merit at all?

Mark Sherman

Brittany writes:

I believe merit-based pay cuts are morally the best route to take in any business, including universities. Like in any other aspect of our lives, we should be rewarded for being overachievers and putting our best effort in even when others are not. Yes, coworkers can be considered part of a team, but if certain people are putting in more time and making up for others they should be repaid for their efforts and given incentives to work harder. I see unequal pay cuts as a way to motivate not only the hard-workers to continue to strive for excellence, but to motivate the slackers to pick it up. I think our country has developed the mentality of “everyone gets a prize” and that if everything is not fair then we hurt someone’s feelings. But life is not always fair and this mentality does not help anyone. I am a Division I athlete and I know what it takes to work hard and to prove yourself on the court. I don’t care who you are, what skills you had naturally, or how old you are, if you work your butt off you are rewarded with playing time. Coaches do not give equal playing time to make everyone happy and the same relates to the business world and even as a student in the classroom. I know there are complications that make it tough to evaluate professors fairly and in a non time and money consuming way; who evaluates the professors? What qualities are best in a professor? There is no perfect evaluation, but in my opinion factoring in the effort and performance of each professor when making decisions on pay cuts is just the right thing to do.

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