Thursday, January 6, 2011

Rethinking employee remuneration: Or why is it difficult to find a taxi when it’s raining

How to set up a remuneration system that gets the best out of your employees continues to be a tricky – and sometimes controversial – topic. Whether it concerns labourers or top managers, it seems difficult to get it right. Individual incentives, team incentives, tying bonuses to firm-wide performance, quantitative metrics, qualitative metrics, stock or options; all of them can potentially stimulate desired performance but could also trigger all sorts of unintended and undesired behaviours.

What does not help is that management theory about remuneration seems often to be based on a set of completely erroneous assumptions about human behaviour. And a theory with the wrong foundations can hardly make helpful recommendations.

Basic assumption: they will work more if I pay them more

Consider, for example, what we call the price elasticity of wages, as defined in economics to capture the relationship between pay and employee effort. Simply put, we tend to assume it is positive: If people make a lot of dosh per hour, we expect them to want to put in more hours. If we reduce the hourly wage, they will be less inclined to want to work many hours and, instead, prefer leisure time; catching a movie, go fishing, or crash out on the sofa holding a beer.

Of course, many people in regular jobs often have to work a fixed number of contractual hours (e.g. 9 to 5), so they don’t really face this choice. Similarly, people who in their jobs are largely judged based on their output, regardless of how many hours they put in (e.g. top managers, violists, professors) don’t get paid “overtime” so they also do not face this choice. However, in some professions people do. More importantly, this assumption – of a positive elasticity between hourly wage and how many hours someone is seeking to work – is the basis of much of the theory of remuneration, and therefore also influences how 9-to-5 workers are paid, and how top managers and violists are remunerated.

The slight problem is, the assumption appears to be wrong…

It is actually quite likely that, in reality (which is hardly the same as economic theory), people’s price elasticity is negative: meaning, if they get paid a higher hourly wage, people start to work fewer hours…

No drivin’ in the rain: NYC taxi drivers

A classic study on this topic was conducted by Professor Colin Camerer and colleagues from the California Institute of Technology. They examined New York City taxi drivers – who basically have to charge a fixed price per mile driven, but can determine for themselves how many hours per day they drive their taxi – and measured the relation between how much money they were making per hour and how many hours they were inclined to work on a given day. And basically what they found was that it is harder to find a taxi when it is raining.

“Eh…?” thou might think, and probably something like “of course it is harder to find a taxi when it is raining, because then they are all occupied”. That might be partially true, and admittedly what I used to think sheltering under an umbrella on a London street corner waiting (in vain) for a free taxi, but there is more going on. And that says something about the relation between remuneration and employee effort.

When it is raining, taxi drivers make more money, at least per hour. Because so many people want a taxi when it is pouring down – likewise when there is a Tube strike or a big convention going on – cabbies make more money per hour. That is because they don’t have to wait long for a new customer or drive around empty hoping someone will flag them down; there is such an abundance of potential customers that they’re hardly ever empty. Consequently, they make substantially more per hour when it is raining than when it’s a sunny day.

Economic theory would now predict that taxi drivers make longer days when it is raining because then they make more money per hour. Vice versa, we’d expect that they go home early when it is sunny (to lie down in the park, play with their kids, or take up knitting – or whatever excites taxi drivers). That sounds quite logical, right? Right… The only problem being that Colin’s research pointed out that the exact opposite is true. When it is a sunny day, and taxi drivers are not getting much buck for their hour, they continue driving and make long days. Instead, when it is raining, and taxi drivers have a high hourly wage, they tend to call it a day early… They, en-masse, were doing the exact opposite of what economic theory would predict. And that is a bit of bummer for our whole remuneration system and theory, because apparently it is built on shaky grounds.

But why…?

The question remains, why would they do that? Colin and colleagues speculated – based on a bunch of interviews with NYC taxi drivers – that people simply apply a different rule in their professional lives. They basically tell themselves, at the beginning of the day, that they have to make a certain amount of money and are then allowed to go home. And the taxi drivers continued driving till they had reached that amount. Some days, they (told themselves they) were lucky because it started raining and they allowed themselves to go home early. Other days – bummer – the sun stayed out and they had to drive longer to reach their target for the day. The vast majority of taxi drivers they interviewed uttered this logic; only one taxi driver said “drive a lot when doing well, quite early on a bad day” (the economists’ prediction), and I guess that’s simply because you always need one exception to confirm the rule.

What does this say about human behaviour? In economic terms this behaviour (“drive till I have reached a certain amount of money”) is plain irrational. As a matter of fact, Colin and colleagues computed that by only adopting the simple alternative rule “drive a fixed number of hours every day”, taxi-drivers could already enhance their income by 50-78 percent. They could increase it with 156 percent if they would just drive more hours when it is raining and less when it is sunny (which, incidentally, would also enable them to spend their leisure time in the sun, rather than inside grumbling at the rain!). Plain irrational indeed. But, as we both know, people aren’t always rational… So perhaps it is also time to rethink how to reward them differently.