This is Compensation subject. Please help me answer the following questions base on your understanding at the given infos.

Questions:

1. Define Demand side of labor. (Base your answer in the given notes. Please explain briefly and clearly)

2. Define Supply side of labor. (Base your answer in the given notes. Please explain briefly and clearly)

3. What does compensating differentials entails? (Base your answer in the given notes. Please explain briefly and clearly)

Notes:

January is always a good month for travel agents in Ithaca, New York. In addition to the permanent population eager to flee Ithaca's leaden skies (our computer has a screen saver whose color is titled "Ithaca"; it consists of 256 shades of gray), graduating stu- dents from Ithaca's two colleges are traveling to job interviews with employers across the country-at company expense, full fare, no Saturday-night stayovers required. When they return from these trips, students compare notes and find that even for peo- ple receiving the same degree in the same field from the same college, the offers vary 207 www.downloadslide.com 208 Part Three External Competitiveness: Determining the Pay Level from company to company. What explains the differences? Location has an effect: Firms in San Francisco and New York City make higher offers. The work also has an effect: Jobs in employment pay a little less than jobs in compensation and employee relations. (Now aren't you glad you didn't drop this course?) And the industry to which the differ- ent firms belong has an effect: Pharmaceuticals, brokerage houses, and petroleum firms tend to offer more than consumer products, insurance, and heavy-manufacturing firms. Students would like to attribute these differences to themselves: differences in grades, courses taken, interviewing skills, and so on. But the same company makes the identical offer to most of its candidates at the school. So it is hard to make the case that an indi- vidual's qualifications totally explain the offers. Why would companies extend identical offers to most candidates? And why would different companies extend different offers? This chapter discusses these choices and what difference they make for the organization. The sheer number of economic theories related to compensation can make this chapter heavy going. Another difficulty is that the reality of pay decisions doesn't necessarily match the theories. The key to this chapter is to always ask, So what? How will this information help me? So grab a box of Krispy Kremes and let's find out. COMPENSATION STRATEGY: EXTERNAL COMPETITIVENESS In Part Two of the book, Internal Alignment, we looked at comparisons inside the organi- zation. In external competitiveness, our second pay policy, we look at comparisons out- side the organization-comparisons with other employers that hire people with the same skills. A major strategic decision is whether to mirror what competitors are paying or to design a pay package that may differ from competitors but better fits the business strategy. External competitiveness is expressed in practice by (1) setting a pay level that is above, below, or equal to that of competitors; and (2) determining the mix of pay forms relative to those of competitors. External competitiveness refers to the pay relationships among organizations-the organization's pay relative to its competitors. Pay level refers to the average of the array of rates paid by an employer: (base + bonuses + benefits + value of stock holdings) / number of employees Pay forms are the various types of payments, or pay mix, that make up total compensation. Both pay level and pay mix decisions focus on two objectives: (1) control costs and increase revenues and (2) attract and retain employees. Control Costs and Increase Revenues Pay level decisions have a significant impact on expenses. Other things being equal, the higher the pay level, the higher the labor costs: Labor costs = (pay level) times (number of employees)Chapter 7 Defining Competitiveness 209 Furthermore, the higher the pay level relative to what competitors pay, the greater the relative costs to provide similar products or services. So you might think that all organizations would pay the same job the same rate. However, they do not. A national survey of over 1,200 entry-level software engineers employed by high-tech compa- nies found an average base salary of $54,300, with a range from $36,500 to $94,000. Why would Microsoft pay more (or less) than Google? What would any company pay above whatever minimum amount is required to hire engineers or other employees? Paying employees above market can be an effective or ineffective strategy. It all de- pends on what the organization gets in return. Let's look at a few examples. Exhibit 7.1 compares labor costs at the U.S. Big Three automakers with those at two Japanese auto- makers (Toyota, Honda) in the United States. It also compares what the companies get in return. As of 2007, U.S. automakers (though let's remember that Fiat owns 58.5% of Chrysler and may soon own more) had higher labor costs, but lower reliability and lower EXHIBIT 7.1 Comparing Compensation Costs across Automakers and Time in the United States 2007 2011 to 2014 Ford GM Toyota Chrysler Honda Ford GM Chrysler Toyota Honda Total labor hours per vehicle 32.2 31.2 Average hourly total compensation $73 $48 $58a $56a $49a $55a $50a Hourly wages $15-$26 $15-$26 $15-$26 Hourly wages (Tier 1) $29 $26 $29 $29 $29 Hourly wages (Tier 2) $14-$19 $14-$19 $14-$19 Consumer Reports Reliability (100 = best) 41 75 % vehicles problem free after 3 years 78 73 74 84 80 Road-test performance (100 = best) 58 76 72 70 58 76 74road test performance ratings on average. GM and Chrysler subsequently went through bankruptcy. One might infer that the Big Three's pay level strategy has not worked for it. (In Chapter 1, we also noted the huge drop in employment among U.S. producers like GM.) As part of that process and also as a result of government involvement, agreements were reached with the United Auto Workers to reduce labor costs to make them competitive with Japanese producers. As Exhibit 7.1 indicates, labor costs for Ford, GM, and Chrysler are now significantly lower than previously. The harder question to answer is whether the qual- ity and performance of the cars will also become more competitive. Exhibit 7.2 pertains to two airline companies, Southwest and USAir. In 2000, USAir trailed Southwest in terms of efficiency, with overall operating costs of 14 cents per avail- able seat mile (ASM), almost double that of Southwest at 7.7 cents per ASM. Likewise, USAir had labor costs per ASM roughly double (5.5 cents versus 2.8 cents) that of South- west Airlines. Part of the cost disadvantage for USAir in 2000 was its higher pay (e.g., for pilots). USAir and other so-called legacy airlines realized that they needed to move their costs lower to compete with Southwest. By 2008, USAir seems to have made consider- able progress, at least with respect to labor costs, which dropped from 5.5 cents per ASM in 2000 to 3 cents per ASM in 2008, almost the same as at Southwest. (Part of USAir's success in reducing labor costs is due to it going through bankruptcy and using that as an opportunity to reduce pay and benefits costs.) USAir's labor costs rose more slowly between 2008 and 2011 than for Southwest. However, there remains a difference not only in overall operating cost, but also in the passenger experience. In all years, South- west had many fewer customer complaints and higher customer satisfaction. If anything, Southwest's advantage in customer satisfaction seemed to have increased between 2000 and 2008 as USAir cut costs. So, although Exhibit 7.2 shows that USAir outperformed Southwest on the financials in 2011, Southwest may continue to be a better bet going forward due to its continued advantage in terms of the customer experience. It is not nec- essarily how much it pays that is the key. Rather, it can be argued that it is its ability to pay competitively and get a great deal in return from its employees. Southwest has been widely studied for its total compensation strategy, which includes employee profit shar- ing and stock, but also having fun at work and strong employee relations. However, there is growing concern that Southwest's labor costs may become a problem. As Exhibit 7.2 shows, it now pays its pilots much more than USAir pays theirs, and the gap widened be- tween 2008 and 2011. For the first time in many, many years, Southwest a few years ago reported losing money. It will be interesting to see what the future brings in the airline industry for companies using different compensation and human resource approaches. Attract and Retain the Right Employees One company may pay more because it believes its higher-paid engineers are more pro- ductive than those at other companies. Their engineers may be better trained; maybe they are more innovative in dreaming up new applications. Maybe they are less likely to quit, thus saving the company recruiting and training costs. Another company may pay less because it is differentiating itself on nonfinancial returns-more challenging and interest- ing projects, possibility of international assignments, superior training, more rapid promo- tions, or even greater job security. Different employers set different pay levels; that is, they deliberately choose to pay above or below what others are paying for the same work. That is why there is no single "going rate" in the labor market for a specific job.3These data are based on comparisons of base wage. When we look at total com- pensation in the bottom of the exhibit. a different pattern emerges. The company still has a different pay level for different job families. But when bonuses, stock options, and benets are included. only marketing managers remain above the market. Every other job family is now substantially below the market. Engineering managers take the deepest plunge, from only 2 percent below the market to over 30 percent below.5 The exhibit, based on actual company data. makes two points. First, companies often set different pay-level policies for different job families. Second. how a com- pany compares to the market depends on what competitors it compares to and what pay forms are included. It is not clear whether the company in the exhibit deliberately chose to emphasize marketing managers and deemphasize engineering in its pay plan or if it is paying the price for not hiring one of you readers to design its plan.\" Either way, the point is, people love to talk about "the market rate" as if a single rate exists for any job, with the implication that organizations are constrained to pay that same rate to their own employees in that job. Nevertheless, Exhibit 7.4 instead shows that organizations can and do vary in how closely they match the "going rate." There is no single "going mix" of pay forms, either. Exhibit 7.4 compares the pay mix for the same job (software marketing manager) at two companies in the same geographic area. Both companies offer about the same total compensation. Yet the percentages allocated to base, bonuses, benets, and options are very different. WHAT SHAPES EXTERNAL COMPETITIVENESS? Exhibit 7.5 shows the factors that affect decisions on pay level and mix. The factors include (1) competition in the labor market for people with various skills; (2) competi- tion in the product and service markers, which affects the nancial condition of the organization; and (3) characteristics unique to each organization and its employees, such as its business strategy, technology, and the productivity and experience of its workforce. These factors act in concert to inuence pay-level and pay-rrrix decisions. LABOR MARKET FACTORS Economists describe two basic types of markets: the quoted price and the bourse. Stores that label each item's price or ads that list a job opening's starting wage are ex- amples of quoted-price markets. You cannot name your own price when you order from Amazon, but Priceline says you can. However. Priceline does not guarantee that your price will be accepted, whereas an Amazon order arrives in a matter of days. In contrast with Amazon's quoted price, eBay allows haggling over the terms and conditions until an agreement is reached; eBay is a baurse. Graduating students usually nd themselves in a quoted-labor market, though minor haggling may occur.7 In both the bourse and the quoted market, employers are the buyers and the potential employees are the sellers. If the inducements (total compensation) offered by the employer and the skills offered by the employee are mutually acceptable. a deal is struck. It may be formal contracts negotiated by unions, professional athletes. and executives. or it may be a brief letter or maybe only the implied understanding of a handshake. All this activity makes up the labor market; the result is that people and jobs match up at specied pay rates. EXHIBIT 7.5 What Shapes External Competitiveness? 234/738 How Labor Markets Work Theories of labor markets usually begin with four basic assumptions: 1. Employers always seek to maximize prots. 2. People are homogeneous and therefore interchangeable; a business school graduate is a business school graduate is a business school graduate. 3. The pay rates reect all costs associated with employment (e.g., base wage, bonuses, holidays. benets, even training). 4. The markets faced by employers are competitive, so there is no advantage for a single employer to pay above or below the market rate. Although these assumptions oversimplify reality, they provide a framework for understanding labor markets. As we shall see later, as reality forces us to change our assumptions, our theories change too. Organizations often claim to be "market-driven"; that is. they pay competitively with the market or even are market leaders. Understanding how markets work requires analysis of the demand and supply of labor. The demand side focuses on the actions of the employers: how many new hires they seek and what they are willing and able to pay new employees. The supply side looks at potential employees: their qualications and the pay they are willing to accept in exchange for their services. Exhibit 7.6 shows a simple illustration of demand and supply for business school graduates. The vertical axis represents pay rates from $25,000 to $80,000 a year. The horizontal axis depicts the number of business school graduates in the market. The line labeled \"Demand\" is the sum of all employers' hiring preferences for business graduates at various pay levels. At $80,000, only a small number of business graduates will be hired because only a few rms are able to afford them. At $25,000, companies 216 Part Three External Competitiveness: Determining the Pay Level EXHIBIT 7.6 Supply and $80,000 Demand for Business School Graduates in Demand the Short Run Pay for business graduates Supply $40,000 - - $25,000 Number of business graduates available can afford to hire a large number of business graduates. However, as we look at the line labeled "Supply," we see that there aren't enough business graduates willing to be hired at $25,000. In fact, only a small number are willing to work for $25,000. As pay rates rise, more graduates become interested in working, so the labor supply line slopes upward. The market rate is where the lines for labor demand and labor supply cross. In this illustration, the interaction among all employers and all business graduates determines the $40,000 market rate. Because any single employer can hire all the busi- ness graduates it wants at $40,000 and all business graduates are of equal quality (i.e., assumption 2 above), there is no reason for any wage other than $40,000 to be paid. Labor Demand If $40,000 is the market-determined rate for business graduates, how many business graduates will a specific employer hire? The answer requires an analysis of labor demand. In the short term, an employer cannot change any other factor of production (i.e., technology, capital, or natural resources). Thus, its level of production can change only if it changes the level of human resources. Under such conditions, a single em- ployer's demand for labor coincides with the marginal product of labor. The marginal product of labor is the additional output associated with the employment of one additional person, with other production factors held constant. The marginal revenue of labor is the additional revenue generated when the firm employs one additional person, with other production factors held constant. Marginal Product Assume that two business graduates form a consulting firm that provides services to 10 clients. The firm hires a third person, who brings in four more clients. The marginalproduct (the change in output associated with the additional unit of labor) of the third person is four clients. But adding a fourth employee generates only two new clients. This diminishing marginal productivity results from the fact that each additional em- ployee has a progressively smaller share of the other factors of production with which to work. In the short term, these other factors of production (e.g., ofce space, number of computers, telephone lines, hours of clerical support) are xed. Until these other factors are changed, each new hire produces less than the previous hire. The amount each hire produces is the marginal product. Marginal Revenue Now let's look at marginal revenue. Marginal revenue is the money generated by the sale of the marginal product, the additional output from the employment of one ad- ditional person. In the case of the consulting rm, it's the revenues generated by each additional hire. If each new client generates $25,000 in revenue, then the third employ- ee's four clients will generate $100,000. But the fourth employee's two clients will generate only $40,000. This $40,000 is exactly the wage that must be paid that fourth employee. So the consulting rm will break even on the fourth person but will lose money if it hires beyond that. Recall that our rst labor market theory assumption is that employers seek to maximize prots. Therefore, the employer will continue to hire until the marginal revenue generated by the last hire is equal to the costs associated with employing that person. Because other potential costs will not change in the short run, the level of demand that maximizes prots is that level at which the marginal rev- enue of the last hire is equal to the wage rate for that hire. Exhibit 7.? shows the connection between the labor market model and the condi- tions facing a single employer. 0n the left is the marker level supply and demand model from Exhibit 7.6, showing that pay level ($40,000) is determined by the interaction of all employers' demands for business graduates. The right side of the ex- hibit shows supply and demand for an individual empioyer At the market-determined rate ($40,000), the individual employer can hire as many business graduates as it wants. Therefore. supply is now an unlimited horizontal line. However, the de- mand line still slopes downward. The two lines intersect at 4. For this employer, the EXHIBIT 7.7 Supply and Demand at the Market and Individual Employer Level Pay for business graduates $80,000 $25,000 Market level > Employer level Market-detemlined pay for business graduates l 2 3 4 5 6 Number of business graduates available Number of business graduates hired marketdetermined wage rate ($40,000) equals the marginal revenue of the fourth hire. The marginal revenue of the fth graduate is less than $40,000 and so will not add enough revenue to cover costs. The point on the graph at which the incremental income generated by an additional employee equals the wage rate is the marginal revenue product. A manager using the marginal revenue product model must do only two things: (1) Determine the pay level set by market forces. and (2) determine the marginal revenue generated by each new hire. This will tell the manager how many people to hire. Simple? Of course not. The model provides a valuable analytical framework. but it oversimplies the real world. In most organizations, it is almost impossible to quantify the goods or services produced by an individual employee, since most production is through joint efforts of employees with a variety of skills. Even in settings that use piece rates (Le. 50 cents for each soccer ball sewn). it is hard to separate the contributions of labor from those of other resources (eicient machines, sturdy materials, good lighting, and ventilation). So neither the marginal product nor the marginal revenue is directly measurable. However, managers do need some measure that reects value. In the last two chapters. we discussed compensable factors, skill blocks, and competencies. If compensable factors dene what organizations value. then job evaluation reects the job's contribution and may be viewed as a proxy for marginal revenue product. However. compensable factors are usually dened as input (skills required, problem solving required, responsibilities) rather than value of output. This same logic applies to skills and competencies. Labor Supply Now let us look more closely at the assumptions about the behavior of potential em- ployees. This model assumes that many people are seeking jobs, that they possess accurate information about all job openings, and that no barriers to mobility (discrimi- nation. licensing provisions, or union membership requirements) eitist.8 Just as with the analysis of labor demand, these assumptions greatly simplify the real world. As the assumptions change, so does the supply. For exan'mle, the upward sloping supply assumes that as pay increases, more people are willing to take a job. But if unemployment rates are low, offers of higher pay may not increase supply everyone who wants to work is already working. If competitors quickly match a higher offer, the employer may face a higher pay level but no increase in supply. For example, when Giant Foods raised its hourly pay $1 above the minimum wage in the Chicago area, Wendy's and Burger King quickly followed suit. The result was that the super market was paying more for the employees it already had but was still Shorthanded. Although some rms nd lowering the job requirements and hiring less-skilled work- ers a better choice than raising wages, this choice incurs increased training costs (which were included in assumption 3). MODIFICATIONS TO THE DEMAND SIDE The story is told of the economics professor and the student who were strolling through campus. \"Look,\" the student cried, \"there's a $100 bill on the path!\" "No, that cannot be," the wiser head replied. "If there were a $100 bill, someone would have picked it up." The point of the story is that economic theories must frequently be revised to ac- count for reality. When we change our focus from all the employers in an economy to a particular employer, models must be modified to help us understand what actually occurs. A particularly troublesome issue for economists is why an employer would pay more than what theory states is the market-determined rate. Exhibit 7.8 looks at three modifications to the model that address this phenomenon: compensating differentials, efficiency wage, and signaling. Compensating Differentials More than 200 years ago, Adam Smith argued that individuals consider the "whole of the advantages and disadvantages of different employments" and make decisions based on the alternative with the greatest "net advantage." If a job has negative EXHIBIT 7.8 Labor Demand Theory Prediction So What? Theories and Compensating Work with negative Job evaluation and compensable Implications Differentials characteristics requires higher factors must capture these pay to attract/retain workers. negative characteristics. Efficiency Wage Above-market wage/pay level The payoff to a higher wage will improve efficiency by depends on the employee attracting higher ability workers selection system's ability to (sorting effect, Chapter 1) and by validly identify the best workers. discouraging shirking (incentive See the appendix at chapter end effect, Chapter 1) because of on utility. An efficiency wage risk of losing high wage job. A policy may require the use of high wage policy may substitute fewer supervisors. for intense monitoring (e.g., use of many supervisors). Sorting & Pay policies signal to applicants How much, but also how Signaling the attributes that fit the (e.g., pay mix and emphasis organization. Applicants may on performance) will influence signal their attributes (e.g., attraction-selection-attrition and ability) by the investments they resulting workforce composition. have made in themselves. Job Job requirements may be As hiring difficulties increase, Competition relatively fixed. Thus, workers employers should expect to may compete for jobs based on spend more to (a) train new hires, their qualifications, not based (b) to increase compensation, or on how low of a wage (wage (c) search/recruit more. competition) they are willing to accept. Thus, wages are sticky downward. See also internal labor markets.Notice that the discussion so far has dealt with pay level only. What forms to pay the mix questionis virtually ignored in these theories. The simplifying assumption is that the pay level includes the value of different forms. Abstracted away is the distinct possibility that some people find more performance-based bonus pay or better health insurance more attractive. Signaling theory is more useful in understanding pay mix. Sorting and Signaling Sorting. introduced in Chapter 1. is the effect that pay strategy has on the composition of the workforcewho is attracted and who is retained. Signaling is a closely related process that underlies the sorting effect. Signaling theory holds that employers delib- erately design pay levels and mix as part of a strategy that signals to both prospective and current employees the kinds of behaviors that are sought.16 Viewed through a marketing lens, how much to pay and what pay forms are offered establishes a \"brand\" that sends a message to prospective employees. just like brands of competing products and services.\" A policy of paying below the market for base pay yet offering generous bonuses or training opportunities sends a different signal, and presumably attracts different people, than does a policy of matching the market wage and offering no performance-based pay. An employer that combines lower base pay with high bonuses may be signaling that it wants employees who are risk takers. Its pay policy helps communicate expectations. Check out Exhibit ?.4 again. It shows a breakdown of forms of pay for two com petitors, as well as their relationship to the market. The pay mix at company A em- phasizes base pay (84 percent) more than does the mix at company B (64 percent) or the market average (67 percent). Company A pays no bonuses, no stock options, and somewhat lighter benets. Company B's mix is closer to the market average. What is the message that A's pay mix is communicating? Which message appeals to you, A's or B's? The astute reader will note that at A, you can earn the $112,349 with very little apparent link to performance. Maybe just showing up is enough. At B, earning the $112,748 requires performance bonuses and stock options as well. Riskier? Why would anyone work at B without extra returns for the riskier pay? Without a premium, how will B attract and retain employees? Perhaps with more interesting projects, ex- ible schedules, or more opportunity for promotionsall part of B's \"total pay brand.\" A study of college students approaching graduation found that both pay level and mix affected their job decisions.lg Students wanted jobs that offered high pay, but they also showed a preference for individual-based (rather than team-based) pay, xed (rather than variable) pay, job-based (rather than skill-based) pay, and exible benefits. Job seekers were rated on various personal dimensions-materialism, confidence in their abilities, and risk aversion-that were related to pay preferences. Pay level was most important to materialists and less important to those who were risk-averse. So applicants appear to select among job opportunities based on the perceived match be- tween their personal dispositions and the nature of the organization, as signaled by the pay system. Both pay level and pay mix send a signal, which results in sorting effects (i.e., who joins and who stays with the organization). Signaling works on the supply side of the model, too, as suppliers of labor signal to potential employers. People who are better trained, have higher grades in relevant courses, and/or have related work experience signal to prospective employers that they are likely to be better performers. (Presumably they signal with the same degree of accuracy as employers.) So both characteristics of the ap- plicants (degrees, grades, experience) and organization decisions about pay level (lead, match, lag) and mix (higher bonuses, benefit choices) act as signals that help communicate. MODIFICATIONS TO THE SUPPLY SIDE (ONLY TWO MORE THEORIES TO GO) Two theories shown in Exhibit 7.9-reservation wage and human capital-focus on understanding employee behavior: the supply side of the model. Reservation Wage Economists are renowned for their great sense of humor. So it is not surprising that they describe pay as "noncompensatory." What they mean is that job seekers have a reservation wage level below which they will not accept a job offer, no matter how at- tractive the other job attributes. If pay level does not meet their minimum standard, no other job attributes can make up (i.e., compensate) for this inadequacy. Other theorists go a step further and say that some job seekers-satisfiers-take the first job offer they get where the pay meets their reservation wage. A reservation wage may be above or EXHIBIT 7.9 Labor Supply Theory Prediction So What? Theories and Reservation Wage Job seekers won't accept Pay level will affect ability to Implications jobs if pay is below a recruit. Pay must meet some certain wage, no matter how minimum level. attractive other job aspects. Human Capital General and specific skills Skill/ability requires investment require an investment in by workers and firms. There must human capital. Firms will be a sufficient return (e.g., pay invest in firm-specific skills, level) on investment for the but not general skills. investment to take place. Workers, Workers must pay for for example, must see a payoff investment in general skills. to training.below the market wage. The theory seeks to explain differences in workers' responses to offers. Reservation levels likely exist for pay forms, too, particularly for health insur- ance. A young high school graduate recently told us, \"If I can't nd a job that includes health insurance, I will probably go to college.\" Human Capital The theory of human capital, perhaps the most inuential economic theory for ex- plaining pay-level differences, is based on the premise that higher earnings flow to those who improve their potential productivity by investing in themselves (through additional education. training. and experience).19 The theory assumes that people are in fact paid at the value of their marginal product. Improving productive abilities by investing in training or even in one's physical health will increase one's marginal prod- uct. In general. the value of an individual's skills and abilities is a function of the time. expense. and effort to acquire them. Consequently. jobs that require long and expen- sive training (engineering, physicians) should receive higher pay than jobs that require less investment (clerical work, elementary school teaching).10 As pay level increases, the number of people willing to make that investment increases, thereby creating an upward-sloping supply. In fact, different types of education do get different levels of pay. In the United Kingdom, new graduates with a degree in math. law. or economics will earn around 25 percent more than job seekers their age who do not have a college degree. An extra year of education adds about $4,200 per year. A number of additional factors affect the supply of labor.2| Geographic barriers to mobility among jobs, union requirements, lack of information about job openings, the degree of risk involved, and the degree of unemployment also influence labor markets. Also, nonmonetary aspects of jobs (e.g., time exibility) may be important aspects of the return on investment. PRODUCT MARKET FACTORS AND ABILITY TO PAY The supply and demand for labor are major determinants of an employer's pay level. However, any organization must, over time. generate enough revenue to cover ex- penses. including compensation. It follows that an employer's pay level is constrained by its ability to compete in the producti'serviee market. So product market conditions to a large extent detertnine what the organization can afford to pay. Product demand and the degree of competition are the two key product market factors. Both affect the ability of the organization to change what it charges for its products and services. If prices cannot be changed without decreasing sales, then the ability of the employer to set a higher pay level is constrained. Product Demand Although labor market conditions (and legal requirements) put a oor on the pay level required to attract sufcient employees, the product market puts a lid on the maximum pay level that an employer can set. If the employer pays above the maximum, it must either pass on to consumers the higher pay level through price increases or hold prices xed and allocate a greater share of total revenues to cover labor costs