1. Internal versus External Promotion

For example, consider a consulting firm that makes its best employees partners after some period of time. Such firms occasionally bring in outsiders at the partner level, but more often than not, promotion is from within. Despite the fact that management consulting is quite a general skill, e.g., a top McKinsey consultant, could, within a short period of time be converted to a Booz Allen consultant, mobility of this sort is rare, relative to internal promotion.

Tournament theory provides an explanation of this practice and suggests that in most circumstances, some favoring of insiders over outsiders is appropriate. When outsiders are included in the set of contestants for a particular position, the number of contestants expands. This reduces the probability that any particular individual will win the promotion. More precisely, it reduces the effect of effort on the probability of getting promoted. As a result, individuals who know that they compete with a large number of outsiders tend not to work as hard as those whose competitor pool is limited to those currently at the firm. Increasing the spread between the winner's and loser's prizes can offset the effects of enlarging the set of contestants, but increasing the spread has its disadvantages. All else being equal, risk-averse workers prefer that the difference in prizes between winners and losers be small. If it is possible to increase effort by excluding outsiders then workers are better off except in rare cases. Firms can pay lower salaries, and effort is increased. This is illustrated in figure 6.1. The incentives in the left panel may be just as strong as the incentives in the right panel, even though the spread is smaller. The reason is that there is more competition in the left panel.

This logic implies that promotion from within is a good strategy. The other side of this argument is that introducing outsiders breaks collusion that might occur within the firm. Thus, our next principle:
 

Internal promotion produces better incentives than outside hiring. Outside hiring should only be used when the outside candidate is significantly better than all internal candidates, or when insiders have colluded to put forth too little effort in the past.

1. Empowerment of the Workforce

1. Information: When workers have control, they are more likely to have information. In Jack Stack (a case from your H280 class), workers were given access to the company's books. The company did this to convince the workers that its claims about the desperate nature of firm's situation were not contrived. This approach, sometimes referred to as "open book management," changes worker incentives and labor supply behavior. Giving workers power makes them insiders, which may make things better for the firm. Giving workers power, especially through representatives, may be an important way to inform employees in a credible way about what is happening in the company. When is this a good strategy?
1. The analysis: A worker receives utility U₀ if she does not work, U_F if she works at a fast pace, and U_N if she works at a normal pace.
1. Point: The firm wants workers to work hard when things are tough, but workers prefer not to work too hard. They will do it to save their jobs, but the firm can't convince them that the situation is critical. The workers rank not working, working fast and working normal from low to high. Thus,  U_{0 <} U_F < U_N so will work hard if it is a bad state, which happens with probability (1-p). If they work at the normal rate during the bad state, the the firm will go bankrupt and workers will lose their jobs.
2. If workers do not have the information, then the must choose either to work fast or normal. They work at the normal rather than the fast pace iff  U_F < pU_N + (1-p) U₀ .  Using this expression, the workers are more aggressive, i.e., choose to hold to the normal pace when

1. Alternatives are good (U₀ is high)
2. When normal work is not painful (U_N is high)
3. When fast work is very painful (U_F is low)
4. When p, the probability that good states occur, is high.
1. What do workers choose to do? If they have no information about the state, they must make their decision based on the probability of a given occurrence. This depends on the parameters above. For any given set of U s, they will choose to work fast or normal depending on p. See the following table.

The full information scenario yields correct behavior by workers all of the time. The no-information scenario yields two distortions: workers may work too hard in the good state or probably worse, they do not work hard enough in the bad state.

1. When workers have some power, they can get information that will allow them to behave in a way that maximizes their own benefit. Doing so also helps the firm when workers would have behaved against the interests of the firm.
2. Firms that must worry most about this problem are those that generally face good economic conditions. Their workers will choose to work at normal levels of effort, causing a disaster when things turn bad.
3. Why would a firm ever withhold information? Because when p is sufficiently low, the workers always choose to work hard, which improves the firm's profits to the extent that the firm must bargain with workers over splitting the surplus.
4. Young workers tend to be more aggressive because their current situation is worse relative to their alternatives than for older workers. This may reflect firm-specific human capital or simply a long-term contract that underpays the young and overpays the old.
5. More generally, when workers have a great deal of firm-specific human capital, management is more likely to profit by resisting demands for open book management.
6. Note that informing workers only of the bad state is tantamount to informing them of both states, because they can infer from failure to inform that the state is a good one.
1. Another reason why it may be beneficial to give workers power is that giving workers power induces them to communicate their preferences to the firm. E.g., if workers tell a firm that they like a particular benefit, the firm may be inclined to use the information against the workers, providing that benefit and taking many others away. Since the firm knows that the worker places such a high value on the benefit, there is room to extract surplus from the worker by tightening down on other aspects of remuneration. The worker will not quit because she likes the benefit so much. As a result, workers are reluctant to give this information to the firm. If, on the other hand, the workers have some power and can control the way in which the information is used, they will be more inclined to provide it. (The complete analysis is provided in Chapter 18, pp. 510-13.)

1. They both speak the same "language." Workers who represent the other workers or who make suggestions themselves need to know the vocabulary of the trade and of business. European workers often elect managers to be their representatives on works councils.
2. Information sets are disjoint and relevant. If management knows everything that workers know, then consultation is of less use. Consultation is most useful when workers have different information than managers and when the different information that they possess is relevant to the production process.

 
1. If all of this is so good, why don't firms voluntarily cede power to workers? The reason is that it is difficult or impossible to give up the power without also giving workers some power to capture a larger share of the pie. Let us start with a proposition.
1. To maximize profits, the firm should not give the productivity maximizing amount of power or information to the workforce. To see this, let x denote the amount of power or discretion given to the workers, say through a union. See figure 6.2. The rent of the firm R, depends on x. If workers are given no discretion, R=R0. With some worker discretion, decisions improve and R rises. If too much worker discretion is given, then rent falls because management does not have enough control over decisions. The result is an R(x) function that has an inverted u-shape.

(1) a. R = R(x)

b. = (x) .
 

Will the firm voluntarily cede the socially optimal levels of power to workers? For a profit-seeking firm, analysis of optimizing behavior says "no". The firm will give less than x* power to the council, where x* is defined as the level of worker power that maximizes joint surplus.

Formally, the profit-seeking firm will maximize:

(2) ( 1-(x) ) R(x)

which has the first order condition

-'(x)R(x)+(1-(x))R'(x)= 0

so that

R'(x)='(x)R(x) / (1 - (x)) > 0
 

Since is increasing in x, the r.h.s. of (3) is positive which implies that R' > 0 at the firm's

optimum point. The firm will choose a level of power for the council on the rising part of the rent-producing curve, and voluntarily give workers less power than x*. The optimum point on the firm's profits curve, lies to the left of the social optimum x*.

What about workers? If they could choose the amount of power for the works council, would they choose the socially optimal level? Workers who seek to maximize their share of the total surplus [(x) R(x)] will, by symmetry with the analysis of the firm, fail to select the socially optimal point. Workers will choose a level of power that exceeds x*. They choose x_w in fig. 6.2, shortchanging the interests of capital.

1. Internal promotion provides more incentives for workers than external promotion. External promotion should be used only when the external candidate is significantly better than the internal one. This may reflect difference is ability or the fact that insiders have implicitly colluded to slack off.

2. Open book management makes information available to workers. To the extent that it is to be used, it is most profitable when workers believe that conditions for the firm are generally good and when the firm is dealing with a relatively young workforce or one that does not have a great deal of firm-specific capital. Under these circumstances, they tend to work at too relaxed a pace, even when the firm truly needs the increased effort.

3. Unless workers have control over the way information is used, they will be reluctant to allow management to know their true preferences. This is another benefit to providing workers with some power.

4. Despite the fact that giving more power to workers makes the firm more productive, it is not profitable to give them as much power as would maximize the joint surplus. The reason is that the more power workers have, the larger the share of the rent that they can extract.