Study: Two-Tier Wage Setup Isn’t More Profitable for Companies

Jun 8th 2015
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Think that hiring lower-wage workers to replace more expensive employees will increase profits? Think again, according to a newly published study, The Consequences of Hiring Lower-Wage Workers in an Incomplete-Contract Environment.

As more companies move to areas with lower-wage workers, the type of employment contract that is used and its effect on company profits come into question. That’s especially as companies often will try to bump up profits by replacing current employees with new lower-wage workers.

Companies using so-called complete contracts that include specific incentives tying wages to worker productivity – the more they produce, the more they earn – generally increase profits.

But profit growth isn’t as clear when incomplete, or fixed-wage, contracts are used, especially when only some existing higher-wage workers are replaced with new lower-wage workers, resulting in a mix of wage scales in the workplace.

That was the basis for a new study by assistant accounting professors Patrick Martin and Jason Brown of Indiana University, professor of business administration Donald Moser of the University of Pittsburgh, and behavioral economics professor Roberto Weber of the University of Zurich. The study was published in the current issue of The Accounting Review, a publication of the American Accounting Association.

The authors found that lower wages don’t improve profits because neither the new lower-wage earners nor the existing higher-wage employees worked as hard. And the new workers’ reduced income also reduced their social welfare.

What’s more, the higher-wage workers in an incomplete-contract workplace might work less if they consider the company’s hiring of lower-wage workers as unfair or violating social norms, according to the study.

The study cites earlier accounting research that indicated violations of employee social norms of fairness, trust, and reciprocity affect behavior. Even workers who aren’t directly affected will react negatively to violations of those norms.

“If remaining higher-wage workers lower their effort because they view hiring a new lower-wage worker as unfair or as a violation of a social norm, then this represents a social cost to the firm that would offset the financial benefit of paying lower wages,” according to the study.

The unintended consequences indicate that companies should consider wage savings and potential costs when replacing some existing workers with new lower-wage workers, according to the study.

The results are applicable to any industry, such as the airline and auto industries, involving two different groups of workers in the same workplace who earn different wages for similar tasks, and both groups are aware of this, says Martin in a prepared statement.

“They could also apply to situations in which a company moves some of its operations from a higher-cost to a lower-cost area, whether in the United States or abroad, where both the retained high-scale workers and the new low-scale cohort are aware of the pay gap", he says.

The findings are based on an experiment involving a mock two-tier wage system involving 144 participants, primarily university students, using computers in an economics laboratory.