Economics, Organization and Management Chapter 10: Employment Policy and Human Resource Management Joe Mahoney University of Illinois at Urbana-Champaign

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Human capital refers to the knowledge and acquired skills a person has that increase his or her ability to conduct activities with economic value. Firm-specific human capital includes skill and knowledge that are more valuable in the context of a particular firm. Knowledge of the firm’s accounting systems; Knowledge of the firm’s customers’ needs; and Knowledge of the firm’s standard operating procedures.

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Employment Contracts The employment contract is typically quite imprecise. The employees agree that --- within limits that are rarely completely described and only partly understood --- they will undertake tasks that the employer directs them to do, perhaps using the methods that the employer specifies. Future compensation and even the criteria used to determine future pay and promotions are unspecified. The mechanisms to be used in case of dispute are not stated, nor are the penalties for most violations of the contract. Yet these are among the most important contracts that any of us enter throughout our lives.

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Employment as a Relationship The incompleteness, the implicit nature, and the shape of the employment contract are all responses to the impossibility of complete contracting. The usual contract is much more a relational contract: It frames the relationship, specifying broad terms and objectives and putting in place some mechanisms for decision making when unforeseen events occur. Residual decision-making authority

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Who should have the residual decision-making authority? One reply is that it should be the owners of capital (or the owner’s agent). But, which capital? If the workers’ human capital is at greater risk, then it would be efficient to give them the residual control rights. This is effectively done in many human-capital intensive enterprises. Many accounting, consulting, architectural, and medical-practice firms are organized as partnerships so that the owners of the human capital have the residual control rights. In most employment relationships, however, most of the risk is arguably borne by the owners of the physical capital, and it is then efficient to give them the residual control rights.

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Implicit Contracting: Self-Enforcing Agreements In a self-enforcing agreement the relationship is structured so the parties to the contractual relationship have incentive to abide by the contract for fear of the consequences of violating the agreement. The incentives in self-enforcing agreements require that each party receive a stream of economic rents from the relationship, so that each will be hesitant to do anything that endangers its continuance. In many cases, both the employer and the employee have an incentive to continue the relationship.

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Risk-Sharing in Employment Relations The firm can be treated as risk neutral (perhaps because it is owned by investors with well-diversified portfolios), then, other things being equal, it should seek to insulate risk-averse workers fully against income risk. This provides a value-creating service for the employees while imposing no cost or risk premium on the risk-neutral firm. The expected pay level can be reduced without harming the workers if the firm takes on some of the risk they would otherwise face, and so both sides gain.

Milgrom and Roberts (1992): Chapter 10 Economics, Organization & Management Human Resource Management: Managing the organization’s work force and maintaining the value of the relationship with the employees is a central task of management. Self-Selection: Pay that is linked to performance will be most attractive to those who know (or believe) themselves to be unusually productive because they expect that this pay system will reward them exceptionally well. Signaling: Firms might select employees on the basis of educational attainment or previous work experience, even if these are not directly relevant to the job at hand, provided they are correlated with factors that are of interest.