 Welcome back to the Knowledge Clip. This one is about Chapter 5, The War for Talent, and I'm going to talk about economic theories of attraction and retention. Economists take a rather simplistic view on people, if I may say so. The main idea about economic theories for people and organizations is that they are motivated by money. The Homo economicus is a person that strives for maximum profit with the least possible inputs, the least possible efforts. In The War for Talent, this leads us to thinking about what wages do to the attraction and retention of talent. There are a couple of theories that are used a lot in this context and you'll see that these can be used to estimate what kind of wages organizations should pay in order to attract the people they need in the organization in order to keep them as well. I'll start with the classic one, Adam Smith and the Classic Weights Theory. I'll move on to Neoclassic Weights Theory and then I'll talk about Efficiency Weights Theory and finally I'll talk about internal labor markets and that is closely related to transaction cost theory. So let's start. Like I said, the economists view on labor is that money explains mostly why people come to work. For the employee perspective, this means that for their highest value is their free time. But if you want to really enjoy your free time, you need some income, some money. As a rational being, as a Homo economicus, employees will consider which efforts will bring them the highest rewards and then they will estimate in which circumstances or with which jobs they will have to do the least in order to make the biggest money. So this theory assumes that employees are rational decision makers, that money plays a big important role in there. And employers have the same kind of logic. So they need labor in order to make their companies thrive and to make the products they want to produce. And at the same time, they don't want to pay very high wages because it costs a lot of money and they want to keep production costs as low as possible. So in this rational world, labor is a commodity. It's a good, something that organizations need in order to produce the products that they want to do. And the price for this product is a wage. So wage is literally the price for labor for organizations in order to reach their targets. Wages are perceived as the result of a supply and demand in a market and a labor market is like any market, a market where employees are in, that supply labor and where employers are and they are looking for labor. So they are the demanding party. The very first idea is about this labor market and the supply and demand of wages dates back to Adam Smith and the invisible hand. So the key idea of this free market theory is that the economy is always in some kind of a balance between demand and supply. And the same is true for the labor market. The idea is that if the wages go up, then more people will be inclined to give up some of their free time and start working for a job, for a living. So if the wages increase, also the supply of labor will increase. At the same time, if the wages increase, products become more expensive. If products become more expensive, then the general public will buy less of those products because at some point they become too expensive, then the demand for labor also reduces because the organizations need less laborers to make less products. The results of this interaction is an equilibrium. So a place on the demand to supply lines where they cross and that is where the equilibrium rates exist. So this is the price that organizations have to pay to laborers to make sure that they have all the people they need to produce the products they want to produce and at the same time there is no unemployment because everybody who wants to work has a job. So there is a perfect balance between the demand and supply of labor. So there are a lot of assumptions behind this model. First and foremost, it assumes that everybody knows everything. So they're a rational decision maker. So it's supposed that there's a complete transparency that employees know all about all the salaries in all the other organizations. It assumes that workers are perfectly mobile, that they can just hop from one job to the next. It also assumes that employers can just easily adjust the wages so if it comes too expensive they can just drop the wages again and that there's no government whatsoever. So in a free market economy the interference of governments is really, really low. Well, by explicating these kinds of things you can already assume that this is kind of a theoretical play. The real world is rather different. However, classical wage theory is still dominant in a lot of economic thinking. However, in the newer versions of the theory the neoclassic wage theory there is much more attention for all the so-called frictions that happen in the labor market. So frictions have to do with that there is no complete transparency, that there is no complete information to everyone. So just to scroll over a few of these assumptions that lead to frictions in the labor market. So first there is an imperfect labor supply within the classical wage theory it's simply assumed that everybody could do all the jobs. Well, that's of course not true. There are specialists, there are people that have education for a specific kind of job and like we talked about in the previous clip there are mismatches between what is offered by employees and what is needed in organizations. So there is not a perfect labor supply at all times. Also there is an information asymmetry. Asymmetry means that the different parties and in this case employers and employees they have different information about what is actually the state of the demand and supply of labor. An individual employee can very difficultly as very much problems to determine what all the other organizations are doing. So what is a fair wage for the job that he or she is interested in? So this information asymmetry leads to people either accepting too low wages or at the same time also organizations offering too high wages for example. Also the assumption that workers are perfectly mobile so that they will easily go to another employer once they are not satisfied this is of course not true people are loyal to organizations but they also have work and families and they live in a certain area and they are not always willing to just hop to another job when there is a few cents more to earn in that job. Finally there is a term that is specific to this theory it is called a monopsy and a monopsy means that there is a limited amount of choice so it imposes from externally the limits to the choice that either employers or employees have to the jobs they accept or the salaries that they can pay. So for example in a small village where there is only one employer and the people are hours of travel away to find another village where they could work then this employer has a lot of power to determine the wages and this employer can go below the market average and still the people living in this small village they will still come to this employer because there is no real alternative so that's a monopsy for the price of labour for employees for employers at the same time there is also a monopsy that is caused by for example the minimum wage so the government says so this is the minimum wage that we think is fair for work and that means that employers can't go lower than this minimum wage. So why are all these things important? So the key thing is that they hinder Adam Smith's idea of the perfect free market when there is continuous up and down in wages to make the maximum out of the free market to come to this equilibrium. So frictions they obstruct the realisation of an equilibrium so wages can be too high as compared to what the ideal would be. So what happens if wages are too high as compared to the average wage according to the free market logic? Well that is that high wages remember they attract workers to come to work so they are willing to give up their spare time, their free time and to earn a bit more money and that means that there is an imbalance between the amount of people that want to have a job and the amount of jobs that are offered in the labour market. So that means that there is unemployment and unemployment in this perspective means that there are more people who want to have a job as compared to the job openings who are there. So bottom line according to neoclassic wage theory all these obstructions that disturb the equilibrium lead to eventually unemployment. So like said the minimum wage is an example modern economists try to use these kind of models to predict for example what will happen to unemployment once they use the wage instrument and say okay everybody should earn more, everybody should earn less and also to understand what kind of government interventions for example improve the demand and supply of labour. So they model in all these frictions into sophisticated models to predict how the development of wages will affect the economy and the unemployment as well. For organisations and for human resource management this theory is quite abstract it has no immediate practical application. However the logic behind it comes back in theories about wage setting and in theories about remuneration and I'm going to dive into two of those theories in more detail and you'll see the practical value of this economic thinking for human resource management as well. So moving on to the next theory I'm going to talk about the efficiency wage theory. Well the efficiency wage theory was developed by Shapiro Estiglis already in 1984 and they started thinking of what these frictions and unemployment could mean for individual organisations and their reasons that the fear of being unemployed in a way is a source of motivation that can help organisations to be more effective. In essence if you have the right talent pool the right human capital, organisations are able to better perform. Shapiro and Estiglis stay reasoned with wages so what do wages do to end up with the right talent pool in your organisation? So their logic goes as follows remember the frictions in the labour market and remember the existence of unemployment. If an organisation decides to pay higher wages then the equilibrium would have been perfect according to the demand and supply model of the free labour market then this organisation is actually according to these theories a stupid actor because higher wages lead to higher costs of production therefore they are in a disadvantage as compared to competitions that will pay the average wage to their employees. However, Stiglis and Shapiro say there's benefits in paying more than your competition. As a first example it brings a selection advantage so if you have higher wages in your organisation then employees or workers looking for jobs will be attracted to your organisation and you'll have a selection advantage because the more people apply to jobs in your organisation the better you can select the best employees into your organisation. So higher wages the first effect is that you are able to select better candidates and remember human capital if you have better candidates you'll have better performance in return. The second example or the second reason they give why higher wages are effective is that employees they really value this high wage and therefore they probably are less inclined to leave the organisation. They want to stay there because other employers don't pay better wages and therefore you also save costs so that means you have to do less hiring. Hiring is expensive you have to put time and effort to find better employees and less training and also from the previous chapters about human capital and knowledge you know that having a workforce that is experienced and knows each other has a better quality in terms of working together and producing good outputs. So there's an advantage in high wages because employees want to stay. And finally there is a motivation aspect as they reason. So it will lead to increased productivity because employees are motivated by their high salaries. An interesting tweak to the theory as compared to social exchange theory that we've discussed before is that this theory is not so much about a willingness to do good but rather a fear to lose your job if you don't work hard enough. So employees will show increased productivity because they fear that if they don't work hard enough they will lose their precious job with this high salary. So efficiency wage theory is an economic theory that predicts that organizations who pay higher wages are better off than organizations who pay the market price for their employees because it will have all kinds of productivity advantages. So they're economic gains from paying higher wages. So I already mentioned this motivation aspect. The word that comes with it is shirking and I'm going to explicate a little bit more here. So shirking is how the economics think how people can be motivated. And you see that there's a little bit of fear in this reasoning. So how to motivate an employee, a homo-economicist who's there to get the largest profit out of the least of efforts. Well, the reasoning is that if you pay an average salary employees will also show average efforts. And that's what they were, that's what the organizations expect. Higher wages, like I said, they caused a friction as a consequence there's unemployment in the labor market and unemployment is a fearful situation. No person who wants to work wants to be unemployed. So in order to prevent unemployment employees are motivated to work harder to put more effort to make sure that they live up this higher wage. So in the reasoning of Shapiro and Stiglitz higher wages lead to higher effort not because they are motivating a search but because they make employees aware that they should work harder in order to keep their jobs. Right. So let's have a quick look at some implications for human resource management. Of course, where we talk about wages is all about compensation levels. So if you talk about compensation you talk about your salary there's also other kinds of reimbursement company car, holidays. So compensation, the definition is that it's a package deal. It's a package of all the rewards that are offered to employees that can include like said the base salary, bonus, vacation days and so on and so on and so on. It's a total. In the literature you will also come across this concept of total rewards and in some literature that's even beyond the monetary part it also includes having a nice supervisor or all the more social aspects of work. But here if you're talking economic theories let's see compensation as the total monetary package of rewards that is offered to employees in return for their work. So can you use it as an instrument to acquire talent? Well, of course, yes. So companies that offer excellent compensation they are known in the market and also there's some research indicating that companies who do offer excellent monetary compensation they are the better performing organizations. So there's evidence for paying higher wages than your competition. Another thing is that organizations can invest in doing some benchmarking with other organizations to understand how competitive exactly their compensation packages are. So benchmarking is an important tool for human resource management to understand if the compensation offered by the organization is still competitive in the rather labor market. So let's have a look at wages and in relation to talent from a cost perspective. So so far we have only looked to the external labor market so the demand is supply assuming that if you need somebody you just go to the external labor market and you find somebody who can do the job for you. Well in fact that isn't always the case you could also do something different you could also hire somebody in the early stage of their career for a lower wage and then invest a lot in their training and development and then as some day these people will be ready to take on more serious jobs in the organization. So imagine a lot of the large organizations that we know nowadays for example Philips they started a few decades ago it was pretty normal that after your graduation you would join such an organization at a very low level and then you would work in some department here you would go to engineering for a while you would do sales and growing through the ranks at some point you would be ready to enter the highest levels of the organization and become the director of a division or something. There's huge benefits in this kind of approach to talent development. One very important thing is that you are cutting on the costs for recruitment and you're cutting on the costs for training if you hire people that are, go back to the example if you hire somebody, if you're looking for somebody in this organization that is able to lead a division and you hire such a person from the external labor market this doesn't mean that this person is automatically aware of all the company procedures and of all the culture things and about specifics of this kind of industry so there's a lot of training needed to ring such a person into the right shape for leading a big company if this person comes from inside then the experience is already there and the training costs are very, very much less the same is for recruitment of course if you hire somebody internally you don't need to hire to do business with an expensive headhunter or something so the idea is also that since there's no training and onboarding time needed so these people that are promoted are immediately productive and they can therefore have a productivity advantage and interestingly if you recruit people in the organization to hire ranks you don't have to compete on the external labor market so that means that you can provide a little bit lower wages you're not going external you build on the loyalty of people who are already in the organization and therefore the reward can be a bit less so in terms of transaction costs transaction costs being the decision between either am I going to buy something externally or am I going to make something by myself and what is the most cost effective then there is a definite benefit in hiring people from inside the organization and moving them through the ranks for example by means of talent programs and things like that there is however a downside to this model it sounds appealing right it sounds attractive if you use your human resource management systems to develop a perfect workforce within your organization and you don't need to go into the hassles with the external labor market well some of the downsides have been researched as well so especially in terms of hyper flexibility in terms of markets that change continuously if you really need to quickly adapt your organization to the market then this loyal and protected workforce actually hinders flexibility if we look back to the 1980s I know it's a long time ago but that was exactly what happened there was an economic downturn and a lot of the big concomitants like Philips they were struggling with the high costs of having a loyal and protected workforce and they were not competitive on the international market anymore so they had to cut they had to downsize their organizations considerably that led to a lot of frustrations and a lot of pain both in people and in organizations we discussed this a little bit in chapter 4 when we talked about the dynamics of change in organizations so there are pros and cons to internal labor markets the present perspective on internal labor markets is that it's actually good to invest in a core of workers of employees who is well trained and who is prepared also to take the next step so the make decision is still a valuable decision that can be used by organizations to create a good talent pool in the organization but for those employees that can be easily replaced it's easier to make a buy decision so in many organizations nowadays you see a combination of internal labor markets for the core workers so those are typically employees that are harder to find on the external labor market or people that have a strategic value to the strategy of the organization and then a rank of flexible workers for jobs that are that all organizations have easier to exchange we have discussed this dynamics also in chapter 4 when we talked about flexible organizations so here you see the reasoning the economic reasoning behind such models it's a make or buy decision to have the right amount of people for what your organization is supposed to do with the right knowledge of course so this brings me to the end of the economic theories by now you know that compensation is central in economic theories and in the war for talent also you are introduced to the idea of the equilibrium wage which is part of the classic wage theory but it's in reality hindered by loads of frictions in the labor market and policy and well we discussed this efficiency wage theory is a more practical HRM theory which helps us understand why high wages have advantages and then finally we discussed transaction cost theory we said what organizations need to do is to think about which part of their labor core is going to be invested in is going to be made and which part of the labor force is actually attractive to buy on the labor market so don't invest in them too much that's it