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Thank you for reading the Brainwaves newsletter. I’m Drew Jackson, your content curator, and today I’m writing about the personnel economics framework. Let’s dive in.

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Thesis: The personnel economics framework is critical for prospective employees who need to determine which opportunities to take and which to pass on. Businesses can use the framework to attract more competent and valuable employees, a vital component for value maximization.

Economics of Value Creation

Many economic frameworks explain critical decisions that businesses, consumers, and employees make. They provide valuable insights into the way people think and the critical incentives behind each action. Today we’re talking about two of these frameworks: value creation/value capture and its counterpart for personnel economics.

I’ve discussed the value creation/value capture framework previously here. Today I’m expanding on it in a more formal setting, and then I’m adding the personnel economics framework (a very similar framework with a different goal). For brevity’s sake, I’ll only introduce the new framework below.

Personnel economics is the application of economic and statistical approaches to traditional questions in human resources contexts. Personnel economics deals with personnel management within a firm (an internal labor market).

Personnel economics is a relatively new field but is snowballing as firms and economists continue to realize the value of understanding the incentives and structures behind employees and working relationships. Unlike other portions of economics, the models in personnel economics aren’t extremely complicated yet, making them easier for the common person to understand.

Let’s dive in!

Credit ITSM.tools

Value Creation / Value Capture

The framework behind personnel economics is very similar to that of value creation and value capture (the framework for why consumers buy the products/services they do). To begin the explanation, here are some definitions:

• Value Created: Value created refers to the total amount of value created through the transaction, a combination of value for consumers and for businesses (value created = WTP - cost).
• Value Captured: Also referred to as profit, value captured refers to the amount of value created that the business is able to capture as profit (remember, profit = price - cost).
• Consumer Surplus: Consumer surplus refers to the additional benefits the consumer receives from a product or service in addition to the price the consumer paid for the product or service (consumer surplus = WTP - price).
• Willingness to Pay (WTP): Willingness to pay refers to the maximum a consumer is willing to pay for a given product or service. In other words, it is the value of the benefit a consumer receives from a product or service.
• Price: Price refers to the amount of money a consumer pays for a product or service. Price also refers to the amount of money a business receives for a product or service in revenue.
• Cost: Cost refers to the amount of money it costs a business to create/offer a product or service.

Each of the previous can be seen in the following image, the value creation and value capture framework:

What is so important about this diagram?

This diagram is fundamental to how companies operate. For example, this diagram explains what price a company should charge its customers to maximize the amount of purchases. How?

Let’s start with the y-axis. The WTP refers to the maximum a consumer would pay for a product or service, the price refers to the price a consumer pays for a product or service, and the cost refers to the cost the business incurs to provide the product or service. The differences in these lines form value creation, consumer surplus, and value capture.

Value creation is the entirety of the value created in a transaction, equal to the maximum the consumer would pay for a product or service minus the cost the business incurs to provide the product or service. Value creation breaks down into consumer surplus and value capture.

The key to business is to create the most value possible for your customers, in this case, to maximize a customer’s willingness to pay and to minimize your costs. Yet, simply creating value doesn’t make a business successful. The business has to capture some of that value as profit in order to be successful.

So, the key to a successful and extremely profitable business is to create value for customers, and then capture a large portion of that value.

Where does consumer surplus fit in with all of this?

Consumers decide which product to pick based on how much consumer surplus is in it for them. Remember, consumer surplus is the maximum benefit that a consumer receives from a product or service minus the price paid for this benefit. For example, if the maximum a customer is willing to pay for a loaf of bread is $10 and there are two options on the table: (1) priced $4, and (2) priced $6, the associated consumer surplus for each option is $6 and $4, respectively. So, the consumer would pick option 1, the option that provides the consumer with the most consumer surplus.

To give another example, if you were choosing what meal to eat tonight and your options were steak (priced $20, maximum willing to pay $30) and lasagna (priced $12, maximum willing to pay $20), which would you pick?

Let’s compare the consumer surplus each option provides. The steak, priced at $20 with a willingness to pay of $30 provides $10 in consumer surplus. The lasagna, priced at $12 with a willingness to pay of $20 provides $8 in consumer surplus. In this case, assuming you have an infinite amount of money, you would pick the steak.

How does this framework tell businesses what price to charge their customers?

If consumers pick which product to buy based on how much consumer surplus they get, picking the price of your product is easy as you simply need to satisfy 2 inequalities:

• Price > Cost
• Consumer Surplus of Your Product > Consumer Surplus of Your Competitor’s Products

For example, if your company has a cost of $5 for each product, your customers are willing to pay $50 for your product, your competitor’s price is $25, and your customer’s willingness to pay for your competitor's product is $35, what should you charge for your product?

To satisfy our inequalities, let’s do some math. First, your price needs to be greater than your costs. Secondly, your consumer surplus needs to be greater than your competitor’s. Adding in numbers, here’s where we get:

• Price > $5
• ($50 - Price) > ($35 - $25)

Solving for the second inequality, you get $40 > Price. So, combining the two equations gets us the following:

• $40 > Price > $5

Boom! Just like that, we know what price our business should be charging for our product to attract customers in this market.

To reiterate quickly:

• To increase value created: increase WTP or decrease costs
• To increase consumer surplus: increase WTP or decrease price
• To increase value captured: increase price or decrease costs

Credit Forbes

Personnel Economics Framework

Personnel economics uses the same framework as value creation/capture, but instead of providing insights on how companies should price their products in order to attract the most customers and set their businesses up for success, this framework tells us which jobs employees should take and how much employers should pay their employees. First, let’s begin with some definitions:

• Value Created: Value created refers to the value created through the employment in the economy (value created = productivity - disutility)
• Profit: Profit refers to how much added profit comes to the business because an employee was added to the firm (profit = productivity - wage)
• Employee Surplus: The net value the employee receives from the job (employee surplus = wage - disutility)
• Productivity: Productivity refers to how productive an employee is, meaning how much revenue the employee adds (by themselves) to the firm (the marginal revenue that the employee creates for the firm).
• Wage: Wage refers to the wages the business pays to the employee
• Disutility: Disutility is the lowest wage that an employee would take to do the job. Disutility is a measure that tries to quantify an employee’s opportunity cost of taking the job. Rephrased, it is the value of all of the negative things about the job (e.g., commute, poor hours, bad management, bad colleagues, bad culture, etc.).

Each of the previous can be seen in the following image, the personnel economics framework:

What is so important about this diagram?

Each job will have a different wage, provide a different disutility for the employee, and in each job, the employee will have a different level of productivity.

In this case, the personnel economics framework is almost the exact opposite of the value creation/value capture framework detailed in the first section.

Previously, businesses cared about maximizing consumer surplus, as consumers cared about how much consumer surplus they received when comparing products against each other. In the personnel economics framework, instead of maximizing consumer surplus, we’re maximizing employee surplus.

What is employee surplus exactly?

Employee surplus refers to the amount of surplus an employee receives for a job. The two parts of the employee surplus equation are the wages paid, and the lowest possible wage the employee would accept for the job. For example, if the lowest an employee would accept to do a job would be $40k, and the wage paid for the job is $60k, the employee surplus would be $20k (the value the employee would get in addition to the minimum required—the extra value).

What does profit refer to in this scenario?

Profit refers to the incremental profit the business receives from having the employee at the business. This can be interpreted simply as the profit the business has with the employee minus the profit the business has without the employee.

Remember, the profit equation for this framework is the following: profit = productivity - wage. So, if a new employee generates $250k in productivity, and the business pays the employee $100k in wages, the business would net $150k in profit.

Why is this framework important?

Say you’re an employee that’s just been laid off. You’ve applied to 20 jobs and received 3 offers. You can only take one. How can you evaluate the offers in comparison to each other?

• The first offer provides a wage of $100k
• The second offer provides a wage of $500k
• The third offer provides a wage of $80k

On the surface, you would think you would pick the second offer. Maybe, but we need more information to decide:

• The first offer is a chance to be a cherry picker, a 9-7 manual labor job each day. There will be a large physical toll on your body and you will have to commute 40 minutes each way. You determine your disutility for this opportunity is $80k.
• The second offer is a chance to be an astronaut in the first flight of a next-generation spaceship planned to land on the moon. However, as this is an experimental design, the chances of living are 10%. You determine your disutility for this opportunity is $1M.
• The third offer is a chance to be a remote executive assistant, with very few responsibilities and easy hours. You determine your disutility for this opportunity is $30k.

Given this information, now which job do you pick?

• The first job has an employee surplus of $20k
• The second job has an employee surplus of -$500k
• The third job has an employee surplus of $50k

In this case, you would actually pick the third job, the lowest paying job on paper, but the job that provides you the most employee surplus.

What can employers do to provide more employee surplus (and potentially attract a better employee)?

Similar to the concepts discussed in relation to consumer surplus (WTP - price), businesses also have 2 levers to pull to increase employee surplus:

1) Increase wages: By increasing the wages paid for the job, the employee surplus generated by that job is increased (and also looks nicer on the surface to people applying).

2) Decrease the disutility associated with the job: This is more difficult as each employee will have a different level of disutility associated with each job, yet there are some ways that are better than others to decrease disutility. To decrease disutility, employers usually increase the benefits of the job: better healthcare plans, meal reimbursements, remote work opportunities, travel reimbursements, personal parking spaces, etc.

How To Create Value

These two frameworks, value creation/value capture and personnel economics, show how businesses can create value in multiple ways through doing business. The first framework (value creation/value capture) details how businesses can attract consumers and purchases by offering a higher consumer surplus. The second framework (personnel economics) details how businesses can attract employees by offering a higher employee surplus.

There are many different levers in each scenario that businesses can use to influence these effects. Understanding these levers will make you a more efficient and effective business manager, consumer, and prospective employee.

It is through these frameworks that questions such as the following are answered: What job should I pick and why? What products should I buy and why? As a business, how can I maximize my profit by optimizing the consumer surplus I offer? Given my costs and a consumer’s expected willingness to pay, what price should I charge to maximize profits? What wage should I offer on my job posting to attract the most qualified applicants while still maximizing my profits as a firm?

Extremely complex business decisions can be understood simply through these frameworks.

If each business owner, consumer, and prospective employee understood these two frameworks, businesses would run much more efficiently and effectively and would create increased value in the world.

See you Saturday for The Saturday Morning Newsletter,

Drew Jackson

Twitter: @brainwavesdotme

Email: brainwaves.me@gmail.com

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