Piece-Rate versus Wages:

Satellite Glass Revisited

Patrick Legros

January 30, 2009

Abstract

Lazear (2000) documents how a change by a new management from a wage system to
a piece-rate system lead to an increase in productivity (mainly through new hires), and an
increase in profits. One explanation is that the previous scheme was not profit maximizing and
that the new management was able to identify productivity enhancing possibilities. We propose
here a complementary explanation: the wage system was profit maximizing but a change in
outside options made a piece-rate system profit maximizing. This explanation is consistent
with an increase in productivity and an increase in profits and suggests the importance of
outside options in explaining contractual forms.

1 Introduction
Lazear (2000) documents how a change in compensation from hourly pay to piece rate pay by a
new management led to changes in productivity, turnover (mainly through new hires), earnings of
workers, and profit.1 There is indication that the firm is making higher profits after the change in
compensation. Lazear suggests that the firm may have selected a suboptimal compensation system,
something that the new management identified and corrected.2
We show here that the change in compensation scheme is fully consistent with profit maximiza-
tion. We consider a simple model of contracting with outside options that are type dependent. The
model articulates a tradeoff between excluding one type of workers in order to pay lower rents to
the other type and limiting the supply of labor available to the firm. The piece-rate contract serves
as a screening device, but is used only if the associated incentive problem does not lead to rents for
1 The effects are significant: productivity increased by 44% on average, wages increased by 7% which suggests that

profits increased.
2 Given the large productivity gains obtained through piece-rates, another explanation for the failure to adopt

them is their costs of administration and monitoring output. There is no strong indication that the administrative
costs decreased in a significant way before and after the change of management.

1
Draft February 1, 2009 2

the high productivity type that exceed the loss in output that would result if a single wage contract
were offered.
The firm optimally chooses to offer a single contract that attracts only one type of workers
when the difference in outside options is not too large. As this difference increases, a menu contract
becomes optimal, where a menu can be implemented by a piece-rate contract.

2 Outside Options and Piece-Rate Contracts

A firm acts as a monopsonist and a worker can produce an output of y (e) = e, where e ∈ R+ .
Workers can have low or high productivity. The private cost to the worker is cL (e) = e2 /2 for low
type, cH (e) = e2 /2θ for high type, θ > 1. Outside options are vL , vH , with vH > vL .3 To avoid
trivialities, we assume that outside options are compatible with the firm making a nonnegative
profit from hiring a worker under perfect information:

θ 1
vH ≤ , vL ≤ . (1)
2 2

The proportion of high type agents in the population is q ∈ (0, 1).

The agents arrive at the firm at the rate corresponding to their proportions in the population.
There is constant return to scale in labor employed and the firm can employ at most one worker
per unit of time. If the firm offers a contract that attracts both types of agents, there will be a
proportion q of H types and 1 − q of L types, and the profit per worker is the weighted average
between the profit made with a H type and with a L type. If the firm offers a contract that is
attractive to only one type of workers, say the low type, it will face a lower rate of arrival of workers,
and in a given time period only (1 − q) workers can be hired.
The design of contracts serves two roles: first, to minimize the cost to the firm of employing
a given worker, second to attract the types the firm desires. Contracts can be designed to attract
either both types of workers or only one type. When the firm wants to attract only one type, the
allocation is implemented by a wage contract and when the firm wants to attract the two types,
the allocation can be implemented by a piece-rate contract.
This is illustrated in Figure 1, for a typical choice of outside options. First best contracts for
low and high types are at points cL , cH respectively, and indifference curves for the high types are
flatter than those of low types since their marginal cost of effort is lower.
By offering a total compensation of w1 as long as output is greater than θ, only high types
3 Type contingent outside options lead to nontrivial tradeoffs between individual rationality and incentive com-

patibility. see Jullien (2000) for a general analysis, and Legros (2002) for a discussion of the role of outside options
in contracting environments.). Here outside options are taken as exogenous but in general they are themselves equi-
librium outcomes. A full analysis would require going away from partial equilibrium but is beyond the scope of this
note.
Draft February 1, 2009 3

w
uL = vL

uH = vH +“rent”
uH = vH
c0H
piece rate offer
w1 = θ/2 + vH cH wage offer
1
cL
w0 = 1/2 + vL 1/θ

y
1 ŷ θ

Figure 1: Wage and Piece-Rate Contracts

decide to work for the firm and do not get a rent; the cost to the firm however is that of foregone
output since the rate of production is ony qθ rather than qθ + 1 − q.
When first best contracts are offered, high types benefit from selecting cL rather than cH and
would get a ‘rent’ if these contracts were actually offered by the firm. The firm would strictly gain
by offering a contract that gives this level of rent to the high types but induce them to produce
more output, as in c0H in the figure. As we will show, the optimal separating menu contract is
indeed {cL , c0H }.
This separating contract can be achieved by a piece-rate contract: the base salary is w0 =
1/2 + vL and there is a bonus of 1/θ for each unit between 1 and ŷ and a bonus of 1 for each unit
between ŷ and θ, with a maximum total compensation of w1 + ‘rent0 .4
Whether or not a wage contract is best depends on the level of the ‘rent’ compared to the output
loss, and we turn now to this characterization.

3 Wage or Piece-Rate Contracts?

Suppose first that the firm wants to attract both types of workers. By the revelation principle, it is
enough to offer a menu {(wH , yH ) , (wL , yL )} satisfying incentive compatibility (type k selects the
slope of the indifference curve of the high type at cL is 1/θ while the slope at c0H is 1; ŷ is the output for
4 The

which the two tangents originating at cL and c0H intersect.

Draft February 1, 2009 4

contract (wk , yk )) and individual rationality (type k has a utility level from the contract greater
than his outside option of vk ). Let

2
yH y2
uH = wH − , uL = wL − L .
2θ 2

If type H chooses contract (wL , yL ) ,

2
yL
uH (L) = wL −
2θ
θ−1 2
= uL + y ,
2θ L

and if type L chooses contract (wH , yH ),

θ−1 2
uL (H) = uH − y .
2θ H

Profits levels are

2
yH
πH = yH − − uH ,
2θ
y2
πL = yL − L − uL .
2

q is the probability of having a high type worker coming (think of a flow arrival rate in a given
period).
In the second best, IC requires that uH ≥ uH (L) , uL ≥ uL (H) that is,

θ−1 2 θ−1 2
yL ≤ uH − uL ≤ y (2)
2θ 2θ H
∗ ∗
If there is no informational problem, it is optimal to set yH = θ, yL = 1 and u∗k = vk . However,
from (1) and (2), such a solution is possible only if

θ−1 θ−1
≤ vH − vL ≤ . (3)
2θ 2

Hence the difference in outside options cannot be too small (otherwise H type prefers the L
contract) and cannot be too large (otherwise the L type prefers the H contract). When (3) does
not hold, the firm can either distort the rents uk or the target output levels yk in order to attract
(or retain) workers. Contracts can be designed to attract both types of agents or to attract only
one type of agent. If the firm wants to attract both types of agents, the profit maximizing menu
solves.
Draft February 1, 2009 5

max qπH + (1 − q) πL
ui ,yi
1θ−1 2
uH − uL ≥ y
2 θ L
1θ−1 2
uH − uL ≤ y
2 θ H
uH ≥ vH
uL ≥ vL

We characterize in the Appendix these contracts and we summarize our findings in the next
proposition. (The arguments are standard but are included for the sake of completeness.)

Lemma. Suppose that the firm wants to attract both types of agents and offers a menu of contracts
((yH , uH ) , (yL , uL )). The profit maximizing menu having this property always specifies the first best
levels of output yH = θ and yL = 1. Furthermore, only the high types may get a positive rent:
θ−1
(i) If vH − vL ≤ , uH = vL + θ−1
2θ , uL = vL .
2θθ−1 θ−1 
(ii) If vH − vL ∈ 2θ , 2 , uH = vH , uL = vL .

Clearly, if by offering a unique contract (w, y) the firm attracts both types of workers, such a
contract leads to a lower profit than the contract described in the lemma. Hence, a single contract
may improve on a menu only if it attracts a single type of worker and if the profit when the labor
force consists of that type is greater than when a menu is used. A necessary condition is therefore
that the outside options are such that we are in case (i) of the lemma. Assume for now on that

θ−1
vH − vL < (4)
2θ
.
If the first best contract for type L is used w∗ = 1
+ vL , y ∗ = 1 , only type L wants to be hired


2
θ−1
only if uH (L) ≤ vH , or if vH − vL ≥ 2θ , which is contradicts (4).
If the first best contract for type H is used w∗ = θ
+ vH , y ∗ = θ , only type H wants to be


2
θ(θ−1)
hired only if uL (H) ≤ vL , or if vH − vL ≤ 2 , hence if (4) holds since θ > 1. Therefore, if the
firm benefits from attracting only one type of agent, it will offer the first best contract for the high
types. It remains to verify whether this is indeed optimal.
Let π (2) be the profit level under the optimal menu described in case (i) of the Lemma and π (1)
be the profit level at the first best contract for the high types. Then,
Draft February 1, 2009 6

   
(2) θ θ−1 θ
π =q − vL − + (1 − q) − vL
2 2θ 2
 
θ
π (1) =q − vH
2

A single contract is optimal if π (1) − π (2) ≥ 0, that is when

 
θ−1 1−q θ
vL ≥ vL + − − vL
2θ q 2
vL θ−1 1−qθ
= + −
q 2θ q 2
= φ(vL )

Since vL < θ2 , φ(vL ) < vL + θ−1

2θ and we have,

Proposition. It is optimal to offer a single contract if and only if vH ≤ φ(vL ). Such a contract
attracts only high types.

Within the region [0, θ−1

2θ ], a wage contract is used when vH − vL < φ(vL ) and otherwise a menu
contract giving a rent to the high type workers is selected. Because φ(vL ) increases with vL , the
conditions for optimality of the wage versus piece-rate contract depend both on the difference in
outside options and on their absolute levels. As is apparent from Figure 2, if the outside options of
the low and high types decrease by the same amount, firms will choose “less often” a wage contract.
In particular, the shift from a wage to a menu contract is consistent with the well documented
increase in wage inequality in the last twenty years. Standard explanations like an increase in the
demand for skilled workers and an increase in the supply of low skilled workers would translate in
an increase in vH and a decrease in vL , leading to a move of point v in Figure 2 into the ‘menu
region,’ as indicated by the arrows.
Such a move from a wage contract to a piece-rate contract will lead to an increase in productivity,
in the total wage bill, consistent with the findings in Lazear (2000).

4 Conclusion
We have provided here an explanation for the change from fixed wages to piece-rate schemes based
on a simple tradeoff between productivity and rents accruing to the high type workers. Failure to
use piece rate contracts despite the productivity boost they would generate may not be a sign that
managers failed to maximize profits.
Draft February 1, 2009 7

vH

φ(vL )

θ/2

FB Menu

Wage

θ−1
2θ Menu, rent

vL
0 1/2

φ(0)

Figure 2: Outside Options and Optimal Contractual Form

Draft February 1, 2009 8

This simple model suggests more broadly that in order to explain organizational choice, or
compensation schemes within a firm, it is important to look outside the firm. Outside options
matter most when there is a tension between productivity enhancing organizational choices and
residual profit for the firm deciders. They are obviously part of a general equilibrium where workers
are mobile across firms and sectors. Hence, changes in one sector, e.g., an increase in productivity
due to a sector-specific technological shock, or an increase in the product price, may affect outside
options and lead to restructuring in sectors that have not been affected by such changes.5
Whether this explanation is more relevant than a failure of managers to maximize profits is an
empirical issue. Nevertheless, recent evidence (e.g., Faggio et al. (2007)) that wage inequality within
firms may reflect inequality between firms and industries provides some comfort to the story that
changes in outside options may have been instrumental in leading to the change in the compensation
scheme in the Satellite case.

5 Appendix: Proof of the Lemma

θ−1
Suppose that vH − vL < 2θ .

2 2
   
yH yL
max q yH − − uH + (1 − q) yL − − uL (5)
ui ,yi 2θ 2
1θ−1 2
uH − uL ≥ y (6)
2 θ L
1θ−1 2
uH − uL ≤ y (7)
2 θ H
uH ≥ vH (8)
uL ≥ vL (9)

Let µH , µL , λH , λL be the coefficients associated to constraints (6), (7), (8) and (9) respectively
and L the Lagrangian. Note that we must have yH ≥ yL by (6)-(7).
We cannot have yL > 1 for otherwise LyL < 0 for all µH and we would have yL = 0. Hence
yL ≤ 1.
θ−1 2
If yL < 1 then LyL = 0 when µH > 0. Then, LµH = 0 and uH − uL = 2θ yL . As long as
yH ≥ yL , (7) holds, and µL = 0. But then, LuL = −µH + λL is zero only if λL is positive; hence
uL = vL . It follows that the maximization problem can be rewritten as

y2 y2
   
θ−1
max q yH − H − vL − − (1 − q) yL − L − vL
{yL ,yH } 2θ 2θ 2
5 See Legros and Newman (2008) for a model along these lines in moral hazard settings.
Draft February 1, 2009 9

but this is increasing in yL for yL < 1, a contradiction.

θ−1
Therefore, we must have yL = 1, LyL = 0 only if µH = 0. By assumption vH − vL < 2θ
and therefore (6) can hold when yL = 1 only if uH − uL > vH − vL . However, since the objective
function is decreasing in uH and in uL , it is optimal to bind (6), since (6) with an equality implies
(7). Hence, uL = vL , and uH > vH . But then LyH = 0 when yH = θ. Profit is then,6
   
θ θ−1 1
Π = q − vL − + (1 − q) − vL
2 2θ 2
2
1 (θ − 1)
= +q − vL
2 2θ
θ−1
If vH − vL ≥ 2θ , the first best contracts are incentive compatible and are optimal.

References
Faggio, G., Salvanes, K., and Van Reenen, J. (2007). The evolution of inequality in productivity
and wages: Panel data evidence. NBER, WP 13351.

Jullien, B. (2000). Participation constraints in adverse selection models. Journal of Economic

Theory, 93:1–47.

Lazear, E. (2000). Performance pay and productivity. American Economic Review, 90(5):1346–
1361.

Legros, P. (2002). Adverse selection and contracts: a discussion. In Dewatripont, M., editor, Ad-
vances in Economic Theory, the Eight World Congress. Cambridge University Press, Cambridge.

Legros, P. and Newman, A. (2008). Competing for ownership. Journal of the European Economic
Association, 6:1273–1308.

6 The firm makes positive profits on high type agents since θ2 − θ + 1 /2 > θ/2 > vL .
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