Economics, Organization and Management
Chapters 7 & 11
Milgrom, P. and J. Roberts (1992). Economics, Organization and Management.
Englewood Cliffs, NJ: Prentice Hall, chapters 7, 11 + pp. 154-61, 408-13.
Chapter 7: Risk Sharing and Incentive Contracts
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A response to moral hazard problems are incentive contracts
o Incentive contracts are where individual incentives are
strengthened by holding people at least partially responsible for
the results of their actions, even though doing so puts them to risks
that could be more easily borne by insurance companies
Incentive Contracts as a Response to Moral Hazard
 Actual insurance contracts are also incentive contracts
o Contain provisions that restrict and condition claim payments that
provide better incentives than full insurance without removing the
essential part of coverage
 E.g. deductible clause common to homeowners’ fire and
theft insurance policies requires them to bear the initial
part of any loss but protecting them against large financial
losses
 Automobile insurance is experience rated
 Health-insurance policies often require copayments
 Features designed to encourage insureds to take care and to deter their
excessive use of the insurance
 Similar moral hazard issues arise when devising compensation contracts
for employees in a firm
 Desirable to hold employees responsible for their performance but
subjects them to risk in current or future incomes
 Efficient contracts balance the costs of risk bearing against the incentive
gains that result
Sources of Randomness
 Having pay depend on performance would not generate risk-bearing
costs if employees’ performance could be determined precisely and they
performed as required
 Perfect measures of behaviour are hardly ever available, exposing
employees to risk with PRP
 Compensation based on results instead of care and effort could be more
effective
 Results are frequently affected by random factors outside of employee
control
o E.g. population growth, poor maintenance, design flaws, etc.
 Second source of randomness arises when performance itself is measured
instead of the result, but performance evaluation measures could be
random/subjective
o E.g. supervisor’s subjective perception of employee’s attitude
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Third source of randomness from the possibility that outside events
beyond the control of the employee may affect their ability to perform as
contracted
o E.g. health problems of the employee, family problems, or weather
and traffic conditions
Balancing Risks and Incentives
 Eliminating risk is possible through making compensation completely
unrelated to performance or outcomes
 But in this case, no rewards for good behaviour or punishments for bad
 Important to understand how rational people act in risky situations to
analyse how rational people respond to incentives in insurance-like
contracts:
1. Describe risks precisely with statistics
2. Describe how rational people, acting individually, can choose
consistently among risky choices
3. Examine how groups of people can share risks and form insurance
pools
Risk Sharing and Insurance
How Insurance Reduces the Cost of Bearing Risk
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Many kinds of institutions that assist in sharing risks including insurance
companies
Enables companies to reduce individual risks greatly
o If risks are independent and number of policyholders quite large,
risks are effectively eliminated and insurance works very well
o E.g. risk that you suffer an automobile accident is very nearly
independent of the risk that any other particular person will do so,
therefore automobile insurance is a feasible enterprise
Insurance companies specialise in evaluating individual risks and they
can reduce the cost of risk bearing by pooling the risk-bearing capacity of
policyholders
But some risks are too large and pervasive that they cannot be made
negligible by sharing and cannot be managed by traditional insurance
agreements
o E.g. oil price increase would have such widespread effects,
reducing the effective incomes of most people in oil-consuming
countries, that no amount of risk sharing could insulate them from
the loss
General risks are shared through other markets especially in financial
markets
o E.g. investment risks taken by firms, such as those associated with
a new technology; risk of failure of the technology is borne by
shareholders and this capacity for risk sharing reduces the firm’s
cost of financing the investment, helping to promote technical
change
Logic of Linear Compensation Formulas
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Commonly observed in the form of commissions paid to sales agents,
contingency fees paid to attorneys, piece rates paid to tree planters or
knitters, crop shares paid by sharecropping farmers, etc.
When sales targets used they are often set to cover short periods of time
so that the periods during which incentives are too low are not extended
ones
Makes compensation of additional sales efforts more nearly equal over
time
Linear systems are also simple to understand and administer
The Informativeness Principle
 In designing compensation formulas, total value is always increased by
factoring into the determinant of pay any performance measure (with
appropriate weighting) that allows reducing the error with which the
agent’s choices are estimated and excluding measures that increase error
(random factors outside agent’s control)
 Comparative performance evaluation according to which the
compensation of an employee (typically manager or executive) depends
not just on their own performance but on the amount it exceeds or falls
short of someone else’s performance
 When is comparative performance evaluation a good idea?
o E.g. in automobile insurance, collision coverage is insurance that
pays the owner of an automobile when their own auto is damaged
in a collision vs. comprehensive damage coverage is insurance that
pays for damage to the persons’ automobile when it is stolen or
damaged by other means (environmental etc.)
o Both kinds of coverage usually work by specifying a deductible
which is the portion of the loss that the insured person must pay
before any payment is due from the insurance company
o If a car owner takes care of his car but in the case of a collision or
theft, the owner has no control over the size of the loss suffered
o Size of loss provides no information about the care taken by the
owner
o According to informativeness principle, the owner’s contribution
toward any loss should not depend on the size of loss but only on
the most informative performance indicator
o In an optimal insurance contract, the owner’s contribution should
not depend on the size of the loss but should be a fixed contract
The Incentive-Intensity Principle
 The optimal intensity of incentives depends on four factors: incremental
profits created by additional effort, precision the desired activities are
assessed, agent’s risk tolerance and agent’s responsiveness to incentives
 E.g. counterproductive to use incentives to encourage production workers
to work faster when their production already exceeds what the next stage
in the production line can use
 More risk averse agents ought to be provided with less intense incentives
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Low precision of measurement leads to high variance, thus weak
incentives should be used; wage incentives should only be used when
good performance is easy to identify
Incentives should be most intense when agents are able to respond to
them
o E.g. in Japanese practice, the amount paid by a manufacturing firm
for its inputs depends on the actual costs as measured in the
supplier company’s accounting records rather than being a
contractually fixed price
o Evidence obtained is consistent with the theory: incentive
contracts for Japanese suppliers do appear to depend on the
considerations identified by the theory
Monitoring Intensity Principle
 Comparing two situations, one with B set high and another with it set
lower, we find that V (variance) is set lower and more resources are spent
on measurement when B is higher: when the plan is to make agent’s pay
very sensitive to performance, it will pay to measure performance
carefully
Equal Compensation Principle
 When there are several activities being conducted, the employer will be
concerned that employees allocate their time and efforts correctly among
the various activities
o E.g. marketing representatives for a company making speciality
steel alloys perform several activities i.e. solicit business from new
customers, problem-solving services and advice to customers,
gather information, etc.
o If the firm were to only base marketing representatives on
accurately measured current sales figure, it might induce
distortion in their behaviour so they switch their efforts towards
the immediate high-payoff activity
 Profit and reputation goals can be in conflict
 Equal compensation principle: if an employee’s allocation of
time/attention between 2 activities cannot be monitored by the
employer, then either the marginal rate of return to the employee from
time or attention spent in each of the two activities must be equal or the
activity with the lower marginal rate of return receives no time or
attention
Application: Cost Centres and Profit Centres
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Important part of designing incentives is to determine the employees’
performance measures
o E.g. manager of a manufacturing facility that deals with the factory
as a cost centre or a profit centre
o 2 activities that the manager must handle are cost reduction and
revenue generation
o Equal compensation principle implies that if the factory manager is
to be provided with sales-generation incentives at all, then the
incentives need to be of the same strength as those for
manufacturing cost control
Application: Incentives for Teachers
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According to equal compensation, if it is desirable to have teachers devote
some efforts to each of many activities, and if it’s possible to distinguish
the effort put into each, then all kinds of efforts must be compensated
equally
Responsibilities and compensation should be determined together
One proposal for teachers would be to install a system of specialist
teachers who are compensated based on student test scores but not
responsible for other aspects of student performance
Determining the job design and compensation together can sometimes
solve problems that cannot be solved by compensation policy alone
Moral Hazard with Risk-Neutral Agents
 Agent can be perfectly motivated at zero cost by setting b=1, or making
them bear the entire risk
 In the case of automobile insurance, it amounts to having drivers paying
full cash compensation to those who they have damaged
Problems with the risk-neutral agent scenario
 Solution will fail whenever the agent lacks sufficient funds
 Solution will also fail when the risk is nonfinancial and is therefore
difficult/impossible to transfer
Summary
 Several principles govern design of optimal incentive contracts
1. Informativeness principle: cost of providing incentives increases
with the variance of the estimator of the employee’s effort
2. Incentive-intensity principle: strength of incentives should be an
increasing function of the marginal returns to the task, the
accuracy with which performance is measured, the responsiveness
of the agent’s efforts to incentives and the agent’s risk tolerance
3. Monitoring intensity principle: more resources should be spent
on monitoring when it is desirable to give strong incentives
4. Equal compensation principle: if an employee’s allocation of
time and effort between alternative tasks cannot be monitored by
the employer, then the marginal returns earned by the employee
in any tasks to which they actually devote effort to must be equal
5. Ratchet effect: the practice of basing performance targets on past
performance in the same activity
 Various factors not included in models that would make the principalagent problem hard to solve: agent may lack sufficient capital, some
losses are nonfinancial or private information might be had by the agent
Chapter 11: Internal Labour Markets, Job Assignments and
Promotions
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Internal labour markets: long-term employment relationships, limited
ports of entry for hiring, career paths in the firm and promotions from
within
May be more than one internal labour market within a single firm
Labour Market Segmentation Patterns
 ‘Internal labour markets’ defined by Peter Doeringer and Michael Piore in
1970s
o Distinguished between primary and secondary sectors in the
economy
o Primary sector: skilled blue-collar work, most white-collar
positions and technical, managerial, and professional employment
o Secondary sector: unskilled, manual-labour, blue-collar jobs; low
or unskilled service positions (janitors, check-out clerks, waiters);
low or unskilled white-collar positions (office mail-room workers,
filing clerks); and migrant, part-time, and seasonal workers
o Internal labour markets are common but not universal in the
primary sector and absent in the secondary
 Not all primary sector jobs are in internal labour markets
o E.g. medical doctor in private practice is not in any internal labour
market but not in secondary sector either
 Primary sector redefined later; subdivided into differences in level of
entrance standards, promotion and turnover rates, criteria for
promotions, and forms of control
Fairness and Efficiency
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Assignment of some positions in the labour market can be approached as
an equity or justice issue
Fairness not the only issue, where skills and abilities are needed for
specific jobs; efficiency matters too
Question of whether assignment of people divided among segmented
labour markets reflects and promotes efficiency or not
Pay in Internal Labour Markets
 Internal labour markets typically has some insulation of compensation
within the firm from external market forces
 At minimum, firms must compete with other employers at the ports of
entry
Job Classifications and Pay
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“Wages attach to jobs rather than individuals”
Fairly narrow range of pay specified for any job in the internal labour
market
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What any particular employee is paid is then determined by his job
assignment rather than individual productivity or opportunity costs
o E.g. at least for lower-level jobs, many firms have very explicit
salary scales, and the only way to get a raise once an employee’s
pay hits the top of the scale is to get a promotion
o E.g. Stanford University’s practices on job classifications and pay
where non-union staff positions are classified into 27 levels and
pay is attached to a classification level
Caveats and Qualifications
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Even within context of job classification scheme there are still differences
in pay between people assigned to the same job
o E.g. Stanford’s maximum salary corresponding to a job
classification is on the order of 50% more than minimum for that
rank; leaves quite a bit of room within any single job classification
for merit pay or seniority
Many Japanese firms that have internal labour markets employ a “dual
hierarchy” where wages are determined by the skills that the workers
have acquired and their performance (their places in the second,
“rankings” hierarchy)
o Two people doing the same job but at different positions in the
ranking can be paid quite differently
o Increasingly, North American and European firms with internal
labour markets have experimented with and adopted similar
policies, paying for skills rather than for the actual job being done
o This approach is particularly favoured in organisational systems
that put a premium on workers’ being willing and able to move
between multiple tasks quickly in response to changing conditions
The Rationale for Internal Labour Markets
 What accounts for the prevalence of internal labour markets with their
pattern of more-or-less permanent employment?
 How do we explain their features (limited ports of entry, job ladders and
promotion from within, and wages that are at least partially attached to
jobs rather than being determined by individual productivity?
Long-term Employment
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Three factors contribute to the efficiency of long-term employment
relations in internal markets:
1. Increased opportunities to invest profitably in firm-specific human
capital
 Knowledge, skills, and interpersonal relationships that increase
workers’ productivity in current employment
 Workers who have gained firm-specific human capital will be
more efficient than if they moved elsewhere, increasing the
probability that workers will stay with their current employer
 Long-term employment encourages the development of
productive, firm-specific human capital
2. Greater efficacy of efficiency wage incentive contracts in long-term
relationships
 Effectiveness of efficiency wages, reputation mechanisms and
implicit, incomplete contracts increases when people take a
longer-term view and is encouraged by long-term employment
 An efficiency-wage scheme where workers are rewarded with
supercompetitive pay with good performance and being fired if
they are caught shirking requires the possibility that
employment relations could last over many periods
3. Enhanced ability to make an accurate assessment of an employee’s
contributions to long-term objectives by monitoring performance
over a longer period of time
 Difficult to evaluate a manger’s performance in selecting the
new technologies in which to invest until some time has passed
 Difficult to provide incentives for long-term performance to
someone whose employment lasts only for a short period of
time
 If incentives provided for the short-term, this would exacerbate
the problem of long-term incentives because managers would
then have the incentive to focus merely on immediate
performance objectives
 Inability to measure long-term performance can degrade
incentives for all kinds of performance
Promotion Policies
 Promotions serve 2 roles in a company: 1) assign people to the roles
which they can best contribute to the organisation’s success and 2) serves
as incentives and rewards
Promotion Policies and Job Assignments
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Higher-level jobs in the hierarchy typically demand higher levels of
knowledge or skill and involve assignments and responsibilities where
the stakes are higher
Often difficult to tell immediately which jobs are most suitable for a newly
hired employee
Promotion is the most effective mechanism when there is a need for
qualities for higher-level jobs where experience in the organisation is
necessary
Managerial Hierarchies
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Decision-making, supervision and leadership at higher levels in
managerial hierarchies have more impact than those at lower levels
Given the way managerial jobs are usually structured, it is important to
have more productive people at higher-level jobs
The firm will want to put harder-working and more talented mangers in
higher level positions with the very best people at the top
Promotions and Outside Labour Market Competition
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Outsiders to the firm rely on the promotion process to help them identify
the ablest workers
Holding their ability fixed, promoted workers have better outside job
opportunities than unpromoted ones and therefore have to be paid a
higher wage
Because a productive worker must be given a raise when they are
promoted, there may e some desire on the part of the firm to delay
promotions and reduce the number of job categories to maintain
information advantage over outsiders
Parallel Job Ladders
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Tying pay to rank, as is standard in internal labour markets, exacerbates
difficulties
Many companies have responded by experimenting with separate career
ladders for scientists and engineers that do not require them to move into
management to get ahead
o E.g. Analog Devices, Inc., 3M Company (makers of Scotch tape and
Post-It Notes) and IMB
Promotions as Incentives and Rewards
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Play a major role as an incentive in most hierarchical organisations
Helps explain why there are limited ports of entry that are usually lowranking positions
Promotions not as flexible as monetary incentives; even the best people
are infrequently promoted and create competition  dysfunctional
behaviour when cooperation and teamwork are important
Pay attached to Jobs
 Pay based on performance helps competing employers identify the firm’s
most talented and hard-working employees
 Helps explain why pay increases along the hierarchy but does not explain
why it isn’t linked to individual performance or characteristics
Measurement problems
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When performance and productivity are difficult to measure with any
accuracy or even to describe in sufficient detail, attaching pay to jobs
becomes more prominent
Decentralised Pay Determination
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Giving responsibility to individual managers for pay determination
Might work well provided managers have effective incentives that cause
them to internalise the costs and benefits of their compensation decisions
However, achieving such motivation is difficult in many circumstances
Influence costs present another reason to avoid discretion in determining
pay levels
o If similar jobs across the firm are paid similarly and by largely
administrative decision, there is little room for politicking about
pay
Pay Ranges
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Common system for pay determination in internal labour markets can be
seen as a response to these difficulties of specifying and measuring
performance and giving full discretion on pay determination to local
managers
Internal Labour Markets as Systems
 A system with many of the features of internal labour markets can
theoretically solve two problems of lack of verifiability and getting
employees to act efficiently
o Defines a hierarchy of regular jobs plus an entry position
o Attached to each job is a pay level and standard of performance
required on the job
o Higher-level jobs have higher pay and require higher performance
 Under competitive pressure, the wage in any job will have to be equal the
extra value created by a worker who meets the specified performance
standard for the job
 The people who find it worthwhile to perform at the higher level needed
to get promoted will find it much easier to meet the standard needed
whereas less able people will not be able to reach it
 People are promoted to their repeatedly promoted out of jobs for which
they are overqualified until they reach ones where the job demands are
well suited to their individual ability levels
 If the system is properly designed there will be no shirking
o Those that are attempting to reach the level for promotion will
exceed the minimum performance standards and those that have
reached their appropriate level in accordance to their abilities will
find it worthwhile to meet the standards required so as not to be
fired
Properties of the System
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Mimics the features of actual job ladders in internal labour markets
People that perform extraordinarily well are only rewarded with extra
pay from their promotions
Firm receives no rents on employees who have risen as far as they are
going to go in the company and are paid the value of what they produce
Real job ladders have actual pyramid hierarchies unlike the system
Influence Costs, Incentives and Job Assignment
 Fundamental conflict can arise when promotions are used to provide
incentives and to assign the best-qualified people to key jobs
 Best performer in one job may not be the person best suited for a
promotion
 Solution could be to separate promotion and performance incentives
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o But associated with problems of defining and measuring
performance and of motivating managers to do the careful
evaluations needed to use pay as a motivator
Influence costs can arise when it is possible for employees to divert
valuable time to affect apparent qualifications for promotion and when
employees’ time allocations are not observable
A Job-Assignment Problem
 If the person holding the key job were to quit, the firm would suffer an
extraordinary cost in replacing the employee or having the job
temporarily empty
 Employees can spend time on the job in two ways: improving the chances
of a successful outcome in current assignments or developing evidence
about qualifications for the key job
 The workers have no inherent dislike or like for either activity and
without incentives to do otherwise, they are willing to allocate efforts in
any way that the firm’s management may direct
 Two observability problems: attractiveness of any competing offer that
the person who is ultimately promoted may receive is not observable by
the fir; firm cannot observe workers’ choices in allocating current time
and effort or if they are suppressing unfavourable information about
qualifications for the promotion
The Impact of Limited Observability
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Without observability problems, firm’s optimal policy would be simple
Would trade off value of increasingly quality of information about
candidates’ qualifications against the cost of reducing expected output in
current jobs, and direct workers to allocate time between the two
Workers would be paid a fixed wage and would be independent of job
assignments
If workers’ allocations of effort could be perfectly observed, pay
differential associated with being promoted would not cause further
problems
o Firm could properly evaluate credentials and make the right
promotion decisions
Moral hazard problem: without direct incentives to work on production,
rational workers would put their effort towards developing credentials to
get a better job
Loss of current output caused by diversion of attention is costly to the
firm and is an influence cost as workers use resources to attempt to
influence which of them would gain the rents from being promoted
Organisational Responses
 Reduce difference in pay between key jobs and others
 Introduce PRP
 Reduce importance of credentials in promotion decision
 It can make performance a criterion in the promotion decision
Optimal Pay and Promotion Policies
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Mix of responses depends partly on importance of promoting the worker
that is better qualified
Important for information on qualifications to be generated but must also
provide incentives for employees to pay attention to current
responsibilities
Must give incentives for productive activity or else it becomes costly for
workers to allocate effort to it
Some degree of performance incentives necessary such as a bonus for
success in current responsibilities
Also useful to reduce the size of pay differential associated with
promotion to reduce the amount of rents and incentives to influence
workers’ ultimate distribution
If promotion criteria doesn’t relate to productivity, using other factors for
promotion such as seniority or a random choice could be made;
credentials should not be a factor in the decision
Might be worthwhile to provide performance incentives by a mix of
methods including PRP and promotion criteria; allows production
incentives to be maintained without having to offer high levels of direct
PRP
The extent that the firm limits the linkage between promotions and
apparent individual performance or qualifications, influence costs can be
reduced
Commitment Problems
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Policy of promoting on seniority, performance or other criteria other than
apparent qualifications brings problems of commitment
If the firm has information about worker’s qualifications, it will
sometimes believe they are promoting the less-qualified person when it is
based on past performance
However, concern for reputation will prevent management from violating
its commitments to employees
Tenure and Up-or-Out Rules
 Someone with formal tenure cannot be fired except for serious cause
 Up-or-out rule means that those denied promotion must leave the
organisation, even despite good current performance
 Practices used in universities, accounting, law and other professional
partnership fields
 Practices are not always linked:
o E.g. tenure is used without an up-or-out rule at Goldman Sachs
where people turned down for promotion are encouraged to stay
on and try again
o E.g. US armed forces have repeated up-or-out rule but no tenure
system
 Why would organisations use these rules?
Tenure
Explanation of Academic Tenure
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Nominal reason for academic tenure is to protect academic freedom;
tenure is meant to make professors feel less afraid to espouse unpopular
positions or take risks on research
Incumbent faculty fear that the university will replace them with younger,
better qualified and productive people but they are only identified
through incumbent and then brought into the system
Unless incumbents are unconcerned with identifying good candidates will
endanger their own welfare, they will have incentive to misrepresent
candidates
Tenure system provides simple solution: people who have met tenure
criteria cannot be fired simply because their talents or performance levels
have deteriorated or their particular field is no longer in demand, thus
they have no reason to fear hiring of people who are better qualified than
they are and no reason to misrepresent the quality of candidates
Applicability to Other Contexts
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Idea that tenure is a system that encourages professionals to properly
represent new job candidates also applies in law, accounting and other
professions where partnerships are common
Tax or bankruptcy attorneys are especially well positioned to evaluate
potential hires in their areas of expertise, so the firm relies on their
appraisal of new candidates
Without tenure, senior people will have incentive to screen out best
candidates and is especially dangerous in large firms and firms that share
profits on a seniority basis
A Learning Explanation
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Alternative explanation to tenure is that it seems to have more
applicability to situations where acquired professional expertise is not a
major factor
If there were only 2 kinds of jobs (productivity largely insensitive to
innate ability or talent plays a key role in determining success), an
efficient allocation of individuals to jobs is not immediately achievable
o Efficiency requires that low-ability people should be assigned to
the jobs where ability is unimportant and high-ability to abilitysensitive jobs
o Supposed that ability levels are not directly observed, including
individuals themselves
If an individual enters a sensitive job, their output generates a signal
about their ability
Eventually after experience, quality of the match between individuals and
their jobs will be almost completely learned
Person will either move to the other type of job or become permanently
matched to the sensitive job
The person effectively has tenure in the ability-sensitive job because even
if they perform poorly in the future, the estimate of ability will still remain
sufficiently high that their expected productivity is still higher in the
sensitive job
Up-or-Out Rules
 One explanation starts from tenure is usually associated with a quantum
jump in earnings, often with no major increase in responsibilities except a
greater role in governance
 Assistant professors = same responsibilities as full professors but junior
people typically paid much less than senior ones
 The organisation collects rents on junior people; their reason for staying
on is the chance for promotion and receive their share of organisation’s
profits and rents from future junior people
 In this context, promotions have little effect on output of the organisation
but they mean that the rents and profits must be shared among more
claimants
 Obvious temptation of organisation to turn down people for tenure or
partner so that the available rents will not have to be shared with extra
people, but offer them competitive wages to stay on
 They might also try to get unsuccessful candidates to stay on at
substandard pay with the promise to try again in the future
 Junior people who recognise this however, will not work hard in hopes of
promotion then and would not invest in firm-specific human capital
(which only gives rents to tenured people) and would not work for less
than market wage
 Up-or-out rules are a means of imposing costs on the decision makers and
gives a complementary explanation: tenure coupled with up-or-out rules
forces those doing evaluations to take them seriously because decisions
made are more important when these practices are in place
 Helps overcome reluctance to bear costs of doing careful reviews of
subordinates
Summary
 Majority of the workers in developed countries becomes attached to a
single employer in a long-term relationship
 Traditional internal labour markets’ feature is their latitude for individual
wage differentials within jobs
 As long as job requirements and tasks remain unchanged over fairly long
periods of time, this system can be effective but with changing
technologies and products, firms may want to encourage more flexibility
from workers, paying wages based on skills than the actual job being
done
o Prevalent in Japan
 Advantages of long-term employment are the acquisition of firm-specific
human capital which allows workers to become more productive; the use
of efficiency wages and of implicit, relational contracts, which loyalty and
fair treatment are enforced by internal mechanisms within the firm and
maintain good reputation; and informational advantages, particularly
superior knowledge that an employer has about its employees’ abilities
that permits giving more incentives and more productive assignments of
workers to jobs
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Internal labour market jobs are arranged in hierarchies
Promotion involves qualitative change in responsibilities
Why promotions over cash bonuses?
o Promotions from within have the advantage that they resemble
tournaments which have 3 important advantages: 1) comparative,
ordinal information about who did better; 2) relative performance
evaluation may be a better bias for compensation if common
factors affect performance of all participants 3) employer has no
incentive to disparage or misrepresent worker performance,
eliminating moral hazard
Attaching pay to jobs and using promotions for incentives mitigates the
need to bargain with individual employees over their salaries
Bargaining is time-consuming, disruptive, and personally costly process,
incurring high influence costs
The firm creates an internal labour market with entry only at the bottom
of the hierarchy, pay in each rank that is insensitive to performance,
higher pay and performance requirements associated with higher-level
jobs, and higher levels of performance being required to be promoted
than merely to avoid being fired
o Leads workers to both select levels of effort that are at nearly
efficient levels and to sort themselves among jobs so that abler
people are promoted to jobs that suit their abilities
Example of influence costs:
o When promotions are based partly on forecasted performance,
candidates have the incentive to build credentials for good jobs
and manipulate decision makers’ perceptions, instead of being
productive
Organisations can reduce influence costs through introduction of pay for
performance to create an offsetting incentive, increasing the weight given
to past performance to promotion decisions, and limiting the input that
employees have to the decision process
Problem of commitment arises when a policy of promoting a lessqualified person is implemented or when it is subjective
Use of up-or-out rules or tenure which are common in certain professions
is questionable
o Theoretically serves a variety of functions: 1) low-level jobs are
continually turned over to allow organisation to import fresh ideas
and perspectives from outsiders or evaluate potential candidates
for higher-ranking positions
o Tenure rules might be designed to encourage professionals to
identify the best candidates, candidates that are so good that they
threaten the professional’s own job
o Up-or-out rules force organisation to promote candidates or lose
their services because there is temptation to hold junior people in
lower-level jobs, but it would destroy incentives and make
recruiting difficult