Efficiency wages and negotiated profit-sharing under uncertainty

Abstract

In this contribution a very simple model of profit sharing as an entrepreneurial instrument to create incentive-based productivity effects was presented. If efficiency gains result, a remuneration contract including shared profits as a premium pay in addition to the market wage is Pareto-superior: By sharing the efficiency gains, both parties, the firm and the worker, are better off compared to a standard wage regime. Furthermore, the efficiency gains due to sharing profits may result in stimulation of labour demand and employment, since the firm´s costs are reduced - though the worker receives a higher overall compensation. However, the focus of this paper is to combine efficiency effects of profit sharing with the impact of an option value which is based on the expected variation of stochastic future profits, if a long-term profit sharing scheme is ex-ante determined. An optimal remuneration policy was presented for two scenarios: First, the firm unilaterally offers a premium based on sharing profits in order to maximise the firm´s profits, and second, a bilateral Nash bargaining solution was computed. In both cases option value effects have to be considered by the firm when permanently determining an optimal instrumental level of the profit sharing ratio given to the worker. The inclusion of expected future revenue variations results in a lower worker´s profit sharing ratio - since a larger variation of revenue implies a higher redistribution of profits from firm to worker if a positive revenue change will occur in the future. In the case of a favourable future revenue development very high profits must be shared with the workers. In contrast, negative future outcomes are truncated, since future losses will not be shared because the firm uses its option to fire a worker in a loss situation, and since the worker has the option to leave the firm and to work elsewhere for the standard market wage. This is anticipated by the firm and results in a lower worker´s sharing ratio which the firm is willing to fix in a long-term wage contract if the sharing ratio is ex-ante determined and held constantly over a period of time.