Pay cuts or job layoffs–which one is better?

My friend’s company sustained substantial losses during this year. The rumor is the company wants to cut costs, either through pay cuts or job layoffs. Which option is better?

Apparently the company is unsure about what to do, and it is contemplating a few options, including the following:

–Survey employees to see their preference
–Ask the partners in the company
–Hire outside consultants

My friend is influential in this decision. He is willing to try any of the methods, but he wants to know the possible biases in each approach. He asked me what I thought from a game theory perspective. I gave a few reactions (don’t take them too seriously!) and he enjoyed them.

With his permission, I am sharing my thoughts. The answers all boil down to the interesting phenomenon of adverse selection.

Adverse selection

Adverse selection happens when a market rule attracts the least desirable applicants to take action. For instance, life insurance policies tend to attract applicants who take high risks. Or all-you-can-eat buffets tend to attract the heaviest, biggest eaters. In both cases, the seller needs to account for the type of buyers who want the offers and adjust expectations and pricing appropriately.

We can use the same idea to analyze a rule change in a company. For instance, it is useful to consider:

–Who finds a pay cut most desirable?

–Who finds layoffs most desirable?

The answer depends on adverse selection, as explained in Game Theory at Work:

Imagine that your firm faces a budget shortfall and absent salary reductions you soon won’t have the funds to meet your payroll obligations. You have two choices: Give everyone a 10 percent wage cut or fire 10 percent of your workers. Adverse selection shows why you should prefer the firing option.

If you give everyone a 10 percent wage cut, some of your workers will probably leave for better-paying jobs. Unfortunately, your most productive workers will probably have the best job opportunities and will consequently be the most likely to quit. Cutting everyone’s wages by 10 percent will cause adverse selection to come into play, since those whom you would most want to stay will be the ones most likely to leave. In contrast, if you fire 10 percent of your employees, you could obviously eliminate your least-productive workers.

Source: James Miller, Game Theory at Work, p. 156

Back to the company choices:

Using this framework, consider again the various choices at my friend’s company.

If it surveys employees, what would they most likely say? Adverse selection suggests they will favor pay cuts. The reason is that a few employees who are the best (and know it) will favor layoffs knowing they are not at risk. The rest of the employees will worry their jobs will be at stake, rightly so, and will favor pay cuts. The problem is made worse because many employees don’t know where they stand. Hence they too will favor the less risky option of pay cuts instead of layoffs.

Now consider the second option. If only the partners were consulted, then they would most likely be concerned with the short-term bottom line. This means they would probably favor layoffs instead of pay cuts to hold the most valuable workers. Adverse selection also suggests the partners with the least long-term stake would be the most vocal, as they would seek to gain and cash out. Short-term incentives like stock options will also influence who participates the most vocally.

And finally, consider hiring an outside consultancy. Consulting firms are often hired to offer an independent evaluation. But they realize that happy clients are repeat clients, and they too are susceptible to adverse selection. Adverse selection means the company is likely to give the most biased data to the consultants who in turn will be influenced to draw a biased conclusion. The company gets what it wanted all along, and it can diffuse blame because it shed decision-making power.

What do you think?

It’s interesting to read about the theory between the two choices, but what do you guys think? Perhaps your answers here can signal a little bit about the readership of this blog :)

(Also, I can empathize with those of you searching for a job and I’ll try to cover some job resources in upcoming posts)



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  • http://bizop.ca michael webster

    Generally, I don’t think much of the adverse selection theory: people generally minimize risk before maximizing reward and the risk reward ratio favours taking a 10 % cut.

    But it all depends on what the company wants to signal: is this a temporary or permanent drop. If temporary keep as much of the staff as possible because it will be hard to hire them back when demand returns. If permanent, then cut costs to the new demand level.

  • Scott

    What about wider-scale economic factors? Is it better for local/regional economy to have 10% people out of work, or to have people with 10% less money?

    On the surface it may seem the same: 10% less money is being spent. That won’t be the case because unemployed workers will still be able to spend money through unemployment or welfare (assuming they don’t get another job). Which is better for the economy?

    Now, some companys may not care about those effects but I would think that many companies that sell a tangible product would. In what way that would influence them, I don’t know, I’m not an economist.

    Another thing to consider is employee initative. I’ve heard of cases where, due to impending layoffs, the employees volunteered to take a paycut instead. In such a case, if the company continued with the layoffs they then would have the additional problem of lower morale.

    Lastly, I wonder if good employees have the level of power you imply here. People’s opinions of their own worth are not necessarily accurate. Bad employees may overestimate their worth while good employees may underestimate it. The only party that actually knows an employee’s worth is the company and I’d imagine that, on average, they play those cards close to their chest. Employees who know they’re good (because the company said so) are in a better bargaining position for raises and promotions. In my experience companies give as much as they think they need to to keep you there while maximizing profit.

  • http://asimjalis.blogspot.com Asim Jalis

    “In contrast, if you fire 10 percent of your employees, you could obviously eliminate your least-productive workers.”

    I would question this premise. Specifically that you would know who your most unproductive workers are. Chances are you will rely on some coarse-grain productivity measurement system. And as a game theorist you will appreciate that these systems can and usually will be gamed. Having such a system in place will tend to decrease altruism within the teams and create an environment in which everyone is out for himself and focused on self-promotion rather than synergies with the rest of the team. A layoff tends to exacerbate these dysfunctions. The best members on such a team will leave, even if they are not targeted by the layoffs — because it’s just not much fun working in these dog-eat-dog environments.

    If you include the effect on the team spirit and environment a pay cut might create more solidarity and create a better work environment than a layoff. And in fact game theory will predict this if you modify the premise that payoff is equal to paycheck and include a positive work environment as part of the payoff.

  • el chief

    “some of your workers will probably leave for better-paying jobs”

    where exactly are these?

    The boss, consultants, and employees don’t necessarily know who the good or bad workers are. The quiet engineer that doesn’t seem to do much might be working on a new competition killer. The loud sales guy that made some bigs sales last year might be lucky or just shipping product that sits on the customers loading dock, to pad his numbers.

    Why is this company hiring bad employees in the first place?

    Why did they wait until bad times to try and fix things?

    Maybe they should think LONG TERM. Experiment with new ideas to hire better people. Train and motivate low performers.

    Cut back hours or pay for everyone in the short term, and fix your company with better HR in the long term.

  • http://www.jeremyfilliben.com jeremy filliben

    You’ve missed the worst of both worlds option: Offering buyouts. In that option, your best workers get paid to leave, while you continue to pay your remaining employees their full salary. It’s a wonder companies use this approach, but many do.

    Of course, great employees love this one!

  • Craig

    re Jeremy, that’s exactly the scenario I have seen played out time and time again — the best employees take the money and run.

  • anomdebus

    Apologies for the brief post. This reminds me of the experiments where they ask people which of two options they would take: a 100% to get x or a 10% chance of getting 10x (else they get nothing). I believe most people choose the certain choice.

  • Gamer

    This doesn’t seem like a 1 vs. group game here. It’s more of a 1vs1 with multiple games. Let’s assume a new game, one where everything about the other player is unknown (like if a company were to hire someone new instead of firing someone it knows).

    Purely thinking game theory here, they are all playing a complex ultimatum game.

    Players:

    The employee: he/she is the decider the one who chooses whether or not to accept the deal.
    The company: is the proposer the one who chooses what to offer the employee (position and payment)

    Rules:

    -There are more than one employee and more than one company.
    -Companies gives “offer” to employee
    -Companies can change offers so long as employee hasn’t said yes or no
    -Employee then accepts or declines
    -One round is played for each game (between one company and one employee)
    -There are multiple games with different players
    -Employee can only accept one offer
    -The company doesn’t know how many other companies have made an offer to the employee that are still valid (could be none, could be multiple, could have declined previous offers)
    -The employee doesn’t know his/her worth to the company (could be hiring a bad employee because of desperation)

    Game:

    So every company must think how much employees do I need and how much can I offer them, while also thinking of how much other companies are offering. The employee thinks how much can I maximize my wage while insuring I receive a job.

    Start: the company thinks it needs 100 employees while the budget is $100, therefore $1 per employee (this doesn’t have to be the case, one employee could receive $0.50 while another receives $1.50). The company then goes and offers a $1 wage to more than 100 employees.

    Employees side: one of two things are happening: the employee is good (in terms of working) and getting plenty of offers or the employee is bad and receives only this one offer. Good employee sees there are better offers and ups the stakes or accepts. Bad employee has to decide: is the company desperate or will they decline if I up the wage.

    Companies side: company wants good employee and thinks of three things, this is his last company he tried to up his wage with everyone else and is trying to do so with me, should I stay at my current offer? Will I be able to pay the rest of the employees if I up the wage? and Is it best to stay at my initial offer? The company also needs bad employee but thinks: what if I can’t get anyone else?

    How does this tie into the whole pay cuts or layoffs dilemma? It does because it’s not about pay cuts or layoffs, it’s about having enough employees within the company and having them stay there.

    If the amount of employees is the amount of employees in the company and the initial offer is the pay cut wage then this can be applied. If enough (what the company needs) of the employees would accept the offer then the company wins and they should do a pay cut. If people try and up the wage however there is enough still employees and budget for those employees then the company should do a lay off. If the company can’t get enough people that fit into the budget then the company loses.

    I don’t know how this can be practically applied to a real life situation though.

    Sorry for the long response.

  • Sorn

    As I’ve heard, often the good ones leave the company if a company eliminates workplaces. They know they wont have a problem with getting a new job, while there is uncertainity in the old one.

    So, probably it would be best to cut down the earnings by 10% but with the promise to pay this back when the crisis has passed (if the employee is still in the company). So, you cut down the salaries now by 10%, but due to the worksmen want the 10%, they’ll stay. In this time period, you can still fire some employees you don’t need due to they’re unproductivity…

    But a big problem in your game theory analysis is imho that you only calculate direct costs. How about saving in computer licences etc. due to lesser employees. But there are different other impacts (I know from Switzerland), f.e. we have to offer some social plan to the people we fire or retire earlier than 65 and stuff like that.

  • rohit ticku

    Interesting read, although i do not think we should restrict HR related issues to such narrow parameters. As empirical research has proven overtime, human behavior is not always rational, the way we define it. Ideas of fairness, belongingness etc do play a role.

    Well, that brings me to a different question. How much a difference expectations make, especially when it comes to bad scenario?

    Say, you have a built in mechanism where salaries are tied to GDP growth, such that in a bad year you know the salaries would be adjusted downwards (and by what proportion). How differently would employees react, compared to a normal circumstance?

  • Marketing

    Personal experience:

    I loved my job for 2 years, until the economy took a crap and political games began in my corporate world. My company opted to cut everyone’s pay by 20% for 3 months, and then add a subsequent 10% cut for the remainder of the year.

    In the fall of 2009 it took 2 months for me to find a company that offered me a job, in my field, with more responsibilities, with a pay that was 25% higher than my orginal salary at my old position.

    When I put in my two weeks notice, 4 other employees also left in an office of 100.

    Trust me, there are jobs. People will leave. Companies that think salary cuts are exceptable will be left with the mutts of the litter.

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