Internal environment

1. 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.”

2. 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.

3. 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!

4. 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.

5. 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.

6. 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.

7. 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!

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.