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Two-tier wage structure not as profitableas widely assumed, new research suggests

Lower pay scales for new workers are met with lower efforts

Sergio Marchionne, CEO of Fiat Chrysler Automobiles, says he wants to end the two-tier wage structure that has been in effect in the company for the better part of a decade. Having two classes of economic packages for employees who do the same work, he recently told reporters, is "impossible. It's almost offensive."

Offensive it may be, but new research suggests another reason why the days of two-tier wages – a higher pay structure for veteran employees than is offered to new ones – may be numbered, not only in the auto industry but in many other enterprises where it has been implemented: The arrangement may not be as highly profitable as generally believed.

On the basis of an elaborate experiment that mimics two-tier systems, a study in the current issue of The Accounting Review, published by the American Accounting Association, concludes that "firm profit does not increase as a result of hiring new lower-wage workers for two reasons. First, new lower-wage workers provide less effort than new same-wage workers and, second, the remaining original workers also provide less effort...than when firms hire new same-wage workers."

The paper identifies "unintended costs of replacing existing workers with new lower-wage workers that neither management accountants who assess the financial feasibility of this strategy nor firm managers who ultimately decide whether to adopt [it] may anticipate."

Comments Patrick R. Martin of Indiana University, a co-author of the study: "Our results apply to any industry in which two groups of workers under the same roof are paid different wages for performing similar tasks and both groups are aware of this – for example, the auto and airline industries. They could also apply to situations in which a company moves some of its operations from a higher-cost to a lower-cost area, whether in the U.S. or abroad, where both the retained high-scale workers and the new low-scale cohort are aware of the pay gap."

Collaborating with Prof. Martin were Jason L. Brown of Indiana University, Donald V. Moser of the University of Pittsburgh, and Roberto Weber of the University of Zurich.

The findings emerge from an intricate experiment involving 144 participants, mostly university students, conducted via computer in an economics laboratory. One fourth of the subjects, 36, were randomly assigned to assume the role of a company, while the remaining 108 participants were assigned to be workers. During the first half of the experiment the 36 firms were each matched with two workers, with the matches changing randomly in each of 15 periods.

The heart of the experiment was its second half, also consisting of 15 periods, in which 36 new workers were added to the labor force. Now each firm was randomly matched with three subjects per period (two originals and one new worker) of whom it could hire two. Of critical importance, half the firms could hire a new worker only at the same wage scale as original employees (20 to 120 laboratory dollars per period), while half could hire a new worker at a lower wage scale of 10 to 120 lab dollars. 

Here’s how it worked. In each of the 30 periods, firms would make an offer to two workers, who were free to accept it (and earn the proffered wage) or reject it (and earn nothing). In return workers would indicate the amount of effort they would provide on a scale of 0.1 to 1.0, with the cost to the worker increasing from zero for a 0.1 effort level to 18 for a 1.0 effort. Worker payoffs were computed by subtracting the cost of their efforts from their wages, while firm payoffs were calculated by subtracting workers' wages from 120 and multiplying the difference by the level of effort.

For example, if a firm offered a wage of 40 laboratory dollars and the worker committed to an effort of 0.6 (for which the associated cost was 8 lab dollars), worker’s payoff for that period would be 40 – 8, or 32.  Firm payoff would be 80 X 0.6, or 48 lab dollars. At the end of the experiment, payoffs were totaled for all 30 periods, and participants were paid in real money on that basis.

Unsurprisingly, firms in the low-wage-scale condition took advantage of new workers: in 146 instances, they offered them wages lower than those of original workers hired alongside them, while this occurred in only 50 instances to new workers hired by firms in the same-scale condition.

What did come as a surprise was the small amount of effort the low-scale new workers were willing to make. They were paid an average of 42 lab dollars per period, which was 32 above the minimum amount they could have been offered, while same-scale new workers were offered 48 lab dollars per period, only 28 above their minimum. Yet, not only did the low-scale workers fail to show their appreciation by committing to greater effort than the other new workers, but they opted for significantly less exertion — 0.24 for the lower-wage-scale new workers compared to 0.30 for those hired at the original wage scale.

Some firms were quick to catch on to this. In the first five periods of the second half (periods 16-20), 88% of new workers were hired by firms in the low-scale condition compared to only slightly over 70% in the succeeding 10 periods.

Meanwhile, the employment of low-wage colleagues also proved to have a detrimental effect on the effort of the original workers hired alongside them. Their average effort level was 0.27 in contrast to 0.33 among originals teamed with a co-worker at the same wage scale, a statistically significant difference. The professors surmise that original workers “react negatively to the firm's decision to hire new lower-wage workers if they believe this violates a social norm. Prior research finds that workers perceive it to be unfair for a firm to exploit an increase in its power to take advantage of its workers," a reaction likely to result in lower job effort on the part of long-termers.

“If lower-wage workers evaluate their wage offer relative to their lower minimum wage,” the professors note, “they could provide the same level of effort for their lower wage that other workers with a higher minimum wage provide for their higher wage. Consequently, firm profit could be higher." The fact that this evidently does not occur and that original workers reduce their effort should lead management accountants to "not only consider the direct wage savings from switching to lower-wage workers but also the potential indirect costs that can arise if hiring such workers results in lower effort."

In conclusion, the professors observe that "anticipating the full effect of replacing existing workers with new lower-wage workers on firm profit is critical because firm managers may not adopt this strategy if they are unsure about the effect on firm profit. Moreover, if hiring new lower-wage workers does not increase firm profit and lowers workers’ payoffs, then social welfare declines. Consequently, even if hiring new lower-wage workers is expected to increase firm profit, some firm managers may decide not to take this action because of the potential negative effect on social welfare."

Entitled "The Consequences of Hiring Lower-Wage Workers in an Incomplete-Contract Environment," the study is in the May/June issue of The Accounting Review, published every other month by the American Accounting Association, a worldwide organization devoted to excellence in accounting education, research, and practice. Other journals published by the AAA and its specialty sections include Auditing: A Journal of Practice and Theory,  Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Journal of Information Systems, and The Journal of the American Taxation Association.

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