HR Pros Ignore Economics at Their Own Peril

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While the students in my personnel economics course were taking their exam recently, I was browsing my twitter timeline. In close succession, two tweets jumped out because of their direct relevance to this course. The subject of each tweet was a failed HR policy, but after only a half-semester of personnel economics, every student in my course should have been able to easily predict the risks of these HR policies based on a basic understanding of the economics behind human behavior. These are two more examples, then, of the importance of equipping HR professionals with an understanding of economics principles.

Here is first tweet:


This story from Salon (Ayn Rand-loving CEO destroys his empire), describes how the CEO of Sears, former fund manager Eddie Lampert, ruined this venerable retailer:

Lampert took the myth that humans perform best when acting selfishly as gospel, pitting Sears company managers against each other in a kind of Lord of the Flies death match. This, he believed, would cause them to act rationally and boost performance.

My students should instantly recognize this as a form of an economic tournament. Tournament theory in personnel economics reveals that the drive to win an economic contest can motivate higher levels of productive effort, but also provides an incentive to engage in influence behaviors (that is, unproductive activities that enhance one's own chance of winning at the expense of organizational goals). So the result was predictable:

Instead of enhancing Sears' bottom line, the heads of various divisions began to undermine each other and fight tooth and claw for the profits of their individual fiefdoms at the expense of the overall brand.

And then the second tweet:

This story from the Daily Mail (Desperate delivery men ditch your Christmas gifts in the BIN) begins with

Couriers paid per parcel they deliver are desperately dumping Christmas gifts in wheelie bins [a wheeled trash can in America], under doormats and in plain sight of the street....These workers, thousands of whom are temporarily employed at this time of year, are given as little as five minutes to drive to an address and drop off a parcel before starting the next order. They are expected to deliver 100 packages in a day -- and will get between 80p to £1 for each one successfully left (though drivers in rural areas will get slightly more). Many are self-employed and have to use their own car or van, and must then deduct all their costs, including fuel, from their pay. They are paid nothing if they leave a 'Sorry you're not in' card. If they have to return the following morning, this trip is usually made in addition to the parcels they need to deliver that day.

This is an example of a simple piece-rate performance-based compensation plan. Basic theorizing in personnel economics indicates that such incentives can be a good motivator. But a basic understanding of economics principles also teaches us to be cautious because poorly-designed incentives can lead to adverse outcomes by self-interested workers as they respond powerfully, perhaps over-powerfully, to these incentives--for example, by pursuing quantity at the expense of quality.

Again, the results of this case are predictable to anyone with an understanding of the economics of human behavior:

As a result, delivery men feel under pressure to find any means possible to empty their vehicles. In some cases, parcels are being abandoned in dustbins -- only for them to be emptied by the bin men. They have been thrown over fences and locked gates, chucked out of moving vans, left in the rain, put in plain sight by a front door, wedged underneath cars parked in driveways and badly hidden under bushes and between shrubs. It means that parcels frequently disappear or arrive damaged.

As both of these unfortunate cases illustrate, it is important that HR professionals develop an understanding of basic economics principles and how they apply to HR issues. This is the domain of personnel economics. As in much of economics, the models used in personnel economics research can seem quite stylized to students and HR practitioners. There are only one or two types of workers, there are only one or two types of tasks. Effort directly yields saleable output either with or without a random error term. And then graphs (or worse, equations!) are used to find optimal outcomes where marginal cost equals marginal benefit. And so forth.

It can be difficult to grasp these stylized models if one tries to understand them by searching for direct examples from real-world applications. My advice is to instead try to understand these models at face value. They are meant to be stylized portrayals of key issues, not literal reflections of real-world complexities. In this way, the key results are clearer, rather than clouded by confounding complexities.

Once this understanding is acheved, then the critical step is to apply the insights in real-world settings. So the value of personnel economics for HR professionals is not in the literal application of stylized economic models; rather, the goal is to develop the ability to translate the insights of the models to real-world applications in ways that reflect a nuanced understanding of employee and employer behavior. The Sears example is not a literal application of a simple tournament theory model, but the insights generated by tournament theory provide important warnings about the behaviors that would be expected to result. The package delivery example also has complexities beyond a basic economics model--there are issues of training, monitoring, bonuses, temporary work--but again, the insights generated by a stylized model greatly help us understand what happened in this messier case.

With that said, it is important to appreciate not only the power of personnel economics, but also the limitations. There are other factors that also help us better understand what happened in these cases. For example, in the Sears case, managers were humilated and spied on. As insightfully noted by the Salon article,

Employees are not just competitive beings -- they benefit from cooperating with each other and perform better when they are respected, rather than beaten down and driven by fear.

So the goal of developing an understanding of economics principles for HR professionals should not be to provide the basis for a dogmatic application of stylized economic theories--the two cases here clearly demonstrate the pitfalls of that approach. But these cases also illustrate that HR professionals should only ignore economics principles at their own peril. Ultimately, workers are very complex beings driven by economic, psychological, social, and other concerns. So HR professionals must develop sophisticated ways of thinking in order to analyze real situations and design policies in a holistic way. This includes, but should not be limited to, thinking rooted in economics.

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About this Blog

Whither Work? is a blog about work created by John Budd. I am a professor of Work and Organizations in the University of Minnesota's Carlson School of Management, and the author of several books including The Thought of Work. Follow me on Twitter: @JohnWBudd.