Chapter Study Outline

16.1 Internal Labor Markets

  • The employment relationship is characterized by the internal labor market (ILM), which:
    • supplants the price and wage system of the external labor market (ELM)
    • directs employee behavior through orders of a job description instead of wage signals
  • The canonical view of an ILM has four stylized properties:
    • The organization has a distinct and stable hierarchy or jobs.
    • Workers have lengthy careers at the firm along a job ladder where promotions are often the result of seniority rather than performance
    • There are distinct ports of entry and exit where the ILM comes in contact with the ELM.
    • Wages are attached to jobs rather than the workers who fill those jobs.
  • The influential work of Baker, Gibbs, and Homström suggests that firms do operate as ILMs that operate in ways similar to the four stylized properties of the canonical viewpoint.
    • Firms especially seem to have hierarchies of jobs .
    • The evidence does not indicate that there are defined ports of entry and exit from an ILM.
    • The evidence also does not indicate that wages are determined by the job rather than the worker attached to the job.
  • Baker and colleagues found that a fast track exists within many firms, in which workers who are quickly promoted from one level to another are quickly promoted all through their careers.
  • Baker and colleagues’ findings show that the starting wage of a cohort of workers entering a firm is largely determined by the ELM but, once inside the firm, the relative wages of all cohorts move in unison, insulated from the ELM.
  • Lazear (1992) also found that firms operate ILMs that are similar in nature to the canonical ILM and showed that job change is key to earnings growth
  • Both the Lazear and Baker and colleague data are drawn from analyzing a single firm, but other, recent studies support their findings.

16.2 Careers I: Investments

  • The long-term nature of many jobs suggests the existence of significant economic forces that bind workers and firms together.
    • Long-term jobs may be partially explained by firm-specific human capital, which is destroyed once the worker leaves the firm.
      • Firm-specific human capital cannot explain the long-term attachment of workers and firms when a worker’s real earnings decline over time (as BGH find is sometimes the case) because wages should go up as workers acquire more human capital on the job.
    • Long-term jobs can also be explained by the fact that firms learn more information about workers’ heterogeneous abilities over time which allows firms to allocate workers to the tasks where they are most productive.
  • Insurance models of compensation have the firm pay a homogeneous initial wage to a set of workers with heterogeneous abilities.
    • This wage floor provides insurance for low-ability workers against low realized ability.
    • Workers with higher ability are eventually rewarded for their relatively higher productivity.
  • In a rat race, workers endure difficult working conditions, which allows high-ability workers (who find the conditions comparatively less onerous) to differentiate themselves from low-ability workers.
  • A reputational investment arises whenever an agent forgoes immediate rewards in order to read future benefits that are rendered possible by either strengthening or maintaining his reputation.
  • An explicit contract is one whose terms are enforceable in a court of law.
  • A relational or implicit contract has unenforceable elements, often because these elements are based on unverifiable information.
    • In order for relational contracts to be effective they must be self-enforcing—for both parties, the short-term gains must be less than the long-term benefits of adhering to the contract .
    • Informal bonus payments are an example of a relational contract.
    • In the career concerns framework, workers realize that there is a link between current performance and future compensation even in the absence of a formal incentive contract.

16.3: Careers II: Payments over Time

  • Because of shirking issues and monitoring difficulties, firms may offer efficiency wages to motivate their employees.
    • In a one-period setting, efficiency wages take the form of a utility surplus for employees.
    • In a multi-period setting, employers may ensure compliance by back-loading earnings, as found by Lazear’s (1979) empirical work.
  • According to the Peter principle, “In an organization, each person rises to the level or his own incompetence.” (Laurence J. Peter)
    • Waldman (1984) argued that inefficient promotion practices that arise because of symmetric ignorance about workers’ true abilities
    • Fairburn and Malcomson (2001) provided evidence that the Peter principal may result as part of a solution to an incentive problem

16.4: Careers III: The Employment Relationship

  • In the make-or-buy decision, a firm must determine whether it is optimal to carry out some activity, X, within its own boundaries or whether it should use the market.
  • Coase posits that there are both important costs to carrying out transactions on the market (finding out relevant prices) and costs to carrying out transactions within the firm (diminishing returns to managerial oversight).
  • The distinction between an employee and an individual contractor (EIC) and benefits of each are commonly seen from three different viewpoints.
  • Multitasking emphasizes that the costs and benefits of the EIC distinction are driven by incentives and that either arrangement can be optimal.
  • From the property rights viewpoint, the EIC distinction results from each distribution of ownership of productive assets, which affect
    • economic power
    • incentives to make costly investments, and
    • residual control rights (the owner of an asset enjoys residual control rights, which are the rights to all uses of an asset in a way not consistent with a prior contract)
  • The authority viewpoint argues that the EIC distinction is important because it determines who ultimately holds the power to overrule certain actions.
    • For a boss, B, and a worker, W,
      • W accepts authority when his behavior is determined by B’s decisions.
        • An individual has formal authority if he has the right to veto a proposal and implement his own plans.
        • An individual has real authority if he effectively controls the decision that is ultimately implemented.
      • W enters into an employment contract with B when W agrees to accept the authority of B and B agrees to pay W a stated wage.