Chapter 20 - Personnel Economics: Hiring and Incentives*

Personnel Economics is the study of the employment relationship. It is unlike most other fields of labor economics for two reasons. First, Personnel Economics has grown up largely within leading business schools, not economics departments. This has given the field a more normative orientation than what is typically found in economics. Because many researchers in this field must take their insights into MBA classrooms and offer advice to future managers, Personnel Economists are typically interested in how firms can solve human resource management problems and how the solutions to HR problems are related to firms’ broader strategic contexts. Second, Personnel Economics is notable in that it is shared between the fields of Labor Economics and Organizational Economics. Because of this, Personnel Economists typically do not treat a firm as a mere “black box” production function. The field is instead interested in understanding and explaining the wide array of human resource management choices made by firms.

Personnel Economics has made great progress in the past few decades, especially in the area of incentives. Personnel Economists, often applying key insights from advances in information economics, have developed theoretical models that capture both the broad issues and many of the details facing firms as they set up incentive systems. Rigorous and clever empirical work has confirmed the relevance of these models and, in some cases, found some potential holes as well. We highlight the success of both empirical and theoretical studies of incentives relative to the literature on hiring. As the labor market continues to get more skilled and employer human resource strategies continue to get more sophisticated, the opportunities to create economic surplus through efficient matching of employees and firms have likely grown and probably will continue to grow. We argue that hiring models developed to date are too far removed from the strategic issues firms face and the empirical work is simply too limited. The relative weakness of the hiring literature is a function of several things, including idiosyncrasies in how firms approach the issues and data limitations. But we are hopeful that new data and new approaches will make research advances possible in this area and we suggest some avenues for future research.

More specifically, we believe that, in developing the literature on incentives in firms, economists have got it right (mostly). Agency-theoretic models—which explain the risk/incentive tradeoff, multitasking, gaming, subjective performance evaluation, career concerns, tournaments, and the like—are probably right (again, mostly). Empirical work has either confirmed the relevance of these theories or researchers have reached a point where limits on measurement preclude sharp tests of the theory. Further, this research provides a good sense for what factors explain across-firm and within-firm variation in the use of various incentive tools. Scholars who teach MBAs at leading (and some not-so-leading) business schools have used these ideas—specifically ideas about firm-level factors that influence the efficiency of various incentive mechanisms—to integrate the economics of incentives into broader discussions of organizational and product-market strategy.

While economists have a lot to say about how a firm can motivate an employee, we have far less to say about how the firm should go about finding the right employee in the first place. We do think there are models that help identify the main economic problem— matching in the presence of search costs and bilateral asymmetric information—in hiring. And there is empirical research consistent with the hypotheses that matching, search costs, and asymmetric information all affect firms’ hiring choices, as well as scattered research on specific strategies that firms might pursue to hire employees.¹

But as business economists, our critique of this hiring literature is that for the most part the firm is treated as a black box. What is lacking is (a) documentation of across-firm variation in hiring strategies, (b) linkage of this across-firm variation in strategy to firmlevel characteristics, and (c) a tie from these facts back to theory. For example, as we shall discuss, Lazear (1998) offers conditions under which hiring risky workers can be a profit-maximizing strategy for firms. But there are notably few studies that examine across-firm variation in propensity to hire risky workers, and then whether the observed variation fits with Lazear’s theory. As another example, Montgomery (1991) suggests that firms can mitigate asymmetric information problems by accessing workers’ social networks in making hiring decisions. But how much across-firm variation is there in network-based hiring? And what exactly does theory lead us to expect about this across-firm variation?

We have two primary goals in writing this survey. First, we hope to encourage Personnel Economists to redirect their efforts (at least partially) away from explaining firms’ choices with regard to incentive compensation and toward firms’ choices with regard to recruitment strategies. We believe such a shift will benefit organizational economics generally, but may also have important spillover effects on other fields of economics. Macroeconomists have, for example, long focused on frictions in labor markets as an important source of business cycles (see Oi, 1962). Second, we offer a catalog of research on firm-level recruitment strategies, in the hope that economists will work to improve this literature.

This isn‘t to say that the marginal social return to research on incentives in organizations is zero. Many unanswered questions remain in that area—especially, we think, surrounding the use of relational incentive contracts and subjective assessments of employee performance—and we look forward to reading that research in the future. But we believe the social return to research on hiring is much larger, both because we know less about hiring, and because hiring the right employee is potentially as important or more so than motivating the employee to take the right action after the employee has been hired (at least for some firms).

We organize this survey as follows. First, we offer a short review of the literature on incentives in organizations. Our aim here is not to be exhaustive or complete (see Lazear and Oyer (2010) for a fuller discussion); instead, we hope to point out some successes and attribute some of the failures to measurement problems that will be hard to solve in future research. Our two broad conclusions here are: (a) we have good answers to many of the big questions, and (b) some of the unanswered questions are likely to be very hard to answer well.

Then, we turn our attention to the question of how firms hire. We outline the basic models of matching, search, and asymmetric information. We discuss the empirical evidence that speaks to the importance of each of these factors. Then we review the somewhat scattered literature on firms’ actual hiring practices. Specific hiring practices we discuss include hiring risky workers, use of labor-market intermediaries, raiding other employers, hiring CEOs, use of various screening techniques, accessing employees’ social networks, and the influence of firing costs on hiring choices. We conclude with a call for new research.