INTERNAL ENVIRONMENT Firms must react to their external environment, but there is little they can do to shape it. In contrast, much of the firm’s internal environment is under the control of the firm and its managers. Therefore one can try to design the internal environment to yield behavior that best promotes the firm’s goals. The fundamental conflict is that, in addition to being in the firm’s business, each worker is also in the “business of me.”

RESOLVING THE CONFLICT The basic principle is to design the environment so that activities that are good for the firm are also good for “me.” This relates to our discussion in Health Econ.: firms won’t create value unless they can capture some of it. The same idea applies to workers. Obviously, this requires incentives, to reward workers for creating value. But that’s not all! You need decision rights that allow workers to exercise proper discretion, an evaluation system that measures value creation, and possibly methods of encouraging the worker to invest in skills that will ultimately benefit the firm.

WHERE WE GO FROM HERE So there are good reasons to understand the economics of labor markets. In particular, we need to understand: Market wage determination, shortages, worker retention Worker investment in skills—human capital Incentives and evaluation Much of this relies on concepts covered previously!

SUPPLY AND DEMAND FOR LABOR Supply of Labor: influenced by training requirements, job pleasantness and risk, alternatives. Note that compensating wage differentials allow workers to sort themselves into most suitable jobs! Demand for Labor: a derived demand, based on labor’s MRP. Results from substitution and scale effects just like any input. Can be elastic or inelastic.

MARKET WAGE DETERMINATION When labor markets are competitive, and many are, then wages match supply and demand: equilibrium. However, this doesn’t usually occur as rapidly as in competitive product markets. As long as wages move fast enough, we don’t need external policymakers to guide employment decisions: firms and workers will automatically respond to the information contained in market wages. Shortages will eventually be corrected through wage movements. Recruiting, retention depend on wages. We will discuss this in our nursing articles.

HUMAN CAPITAL Skills are an investment: it takes time to learn them, the provide a return on investment for many periods, they depreciate. Investments have shown up a few times in this class—investments in health, investments in capital goods, investments in human capital—and we haven’t given them full due. Accounting and finance will spend more time on these topics. The book has a nice illustration of investment in human capital, which we’ll discuss.

GENERAL HUMAN CAPITAL One kind of acquired skills are those that are useful to a wide range of potential employers. These are called “general human capital.” Good examples: academia, physical therapist. In competitive labor markets, workers must be fully compensated for general human capital or be hired away by someone else. Since the worker receives full return on his investment, he/she has full incentive to learn these skills and should be willing to sacrifice to learn them. For people with mostly general human capital, career wage growth mostly reflects skills/productivity acquired on the job. This can be substantial!

SPECIFIC HUMAN CAPITAL I In many firms, skills are required that are specific to the firm. This can be anything from proprietary production processes to knowing how the organization works. This is called “firm specific human capital.” Good examples: machinist, graduate advising. The problem is how to motivate the learning of these skills. Outside firms won’t pay for them so no “external” financial incentive exists as motivation. And learning these skills takes time. So the firm must encourage both skill acquisition and long-term employment.

SPECIFIC HUMAN CAPITAL II Often specific human capital development is behind internal labor markets that stress seniority- based pay, internal promotion, long-term job attachments. Because the firm can’t sell these skills elsewhere, the firm can share or assume the costs of skill acquisition. So it is possible to have more wage compression, as firms share costs of developing specific human capital and the benefit from having it with the worker. Notice that some of these policies can have deleterious incentive effects.

INCENTIVES I Incentives should align worker and firm objectives by paying worker directly for productivity. For example, piece rates, commission. Strongest incentives is when you are a “residual claimant”—you work for yourself! This, incidentally, is an argument for vertical or horizontal “disintegration”—better incentives. However, working for yourself is risky—your income can increase or decrease for reasons beyond your control. Generally, there is a tradeoff between the strength of the incentive and the risk absorbed by the worker.

INCENTIVES II There can be other drawbacks to incentives, all related to the problem of evaluation. If you cannot measure productivity exactly, then workers have an incentive to “game the system”—do things which are rewarded by the incentive structure but do not create value for the firm, or not do things which create value because they are not rewarded. For example, undermining teamwork, forsaking quality for quantity, focusing on short term instead of long term, lack of investment in human capital. The DRG system illustrates the possibility of gaming the system in a non-labor context.

INCENTIVES III If there are no evaluation problems, then optimal incentives follow (sort of) the equi-marginal principle! The marginal product, in terms of productivity, of strengthening the incentives one unit equals the marginal loss to the worker of the additional risk assumed plus the implicit cost (to worker) of additional effort. Notice that this means you are paying worker more, at least on average, when you provide stronger incentives. Thus worker captures some of the value he/she creates.

INCENTIVES IV When evaluation problems are present this gets more complicated. When teamwork is important incentives often should pertain to the entire team. But then there are complications arising from the “free-rider problem.” How do I try to minimize free-rider problems in our applied assignments in this class? Notice also incentives applied to teams are automatically “watered down” since each worker contributes a smaller fraction of final outcome and is exposed to more risk from other workers’ efforts.

INCENTIVES V Incentives need not only pertain to effort. Workers may have knowledge that you don’t (“local knowledge”). You wish to encourage worker to use knowledge in a way that’s advantageous to the firm. For example, if workers can choose between commission-based pay or salary, harder workers will choose commission—they have “revealed” their private knowledge, which firm can’t observe directly. The decision rights given to workers must be consistent with your incentives. If they have a lot of local knowledge that you as a manager do not have, they should probably have greater decision rights.

DESIGNING THE INTERNAL ENVIRONMENT FOR WORKERS Three fundamental components: decision rights, incentives, evaluation systems. We have talked about each individually, in this class and others (management, inf. systems). All three components are complements! The effectiveness of any one component is enhanced by designing the other components properly. Think about each pair: incentives and decision rights, incentives and evaluation, decision rights and evaluation—more of the first is enhanced (made more productive) by more/better of the second.