The Efficiency Implications of Internal Labor Market Structures

The upshot is that none of the above contracting schemes has acceptable properties for tasks of the idiosyncratic variety. Contingent claims contracting (Meade, 1971, Chap. 10) fails principally because of bounded rationality. Spot market contracting (Alchian and Demetz. 1972, p. 777) is impaired by first- mover advantages and problems of opportunism. The authority relation (Simon, 1957, pp. 183-195) is excessively vague and, ultimately, is confronted with the same types of problems as is spot market contracting. Faced with this result, the question of alternative contracting schemes naturally arises. Can more effective schemes be designed? Do more efficient contracting modes exist?

The analysis here is restricted to the latter of these questions, which is answered in the affirmative. Although it cannot be said that internal labor market structures are optimally efficient with respect to idiosyncratic tasks, it is nevertheless significant that their efficiency properties have been little noted or understated by predominantly non-neoclassical interpretations of these markets in the past.

My assessment of the efficiency implications of internal labor market structures is in three parts. The occasion for and purposes of collective organization are sketched first. The salient structural attributes of internal labor markets are then described and the efficiency implications of each, expressed in terms of the language of the organizational failures framework, is indicated. Several caveats, including a brief discussion of atmosphere, follow.

1. Collective Organization

To observe that the pursuit of perceived individual interests can sometimes lead to defective collective outcomes is scarcely novel. Schell- ing has treated the issue extensively in the context of the “ecology of micro- motives” (1971). The individual in each of his examples is both small in relation to the system — and thus his behavior, by itself, has no decisive influ- ence on the system — and is unable to appropriate the collective gains that would obtain were he voluntarily to forego individual self-interest seeking. Schelling then observes that the remedy involves collective action. An enforceable social contract which imposes a cooperative solution on the system is needed (1971, p. 69).

Although it is common to think of collective action as action by the state, this is plainly too narrow. As Arrow (1969, p. 62) and Schelling (1971, p. 68) emphasize, both private collective action (of which the firm, with its hierarchical controls, is an example) and norms of socialization are also devices for realizing cooperative solutions. The internal labor market is usefully interpreted in this same spirit.

Although it is in the interest of each worker, bargaining individually or as a part of a small team, to acquire and exploit monopoly positions, it is plainly not in the interest of the system that employees should behave in this way. Opportunistic bargaining not only in itself absorbs real resources, but efficient adaptations are delayed and possibly foregone altogether. Accordingly, what this suggests is that the employment relation be transformed in such a way that systems concerns are made more fully to prevail and the following objectives are realized: (1) bargaining costs are much lower: (2) the internal wage structure is rationalized in terms of objective task characteristics; (3) consúmate rather than perfunctory cooperation is encouraged: and (4) investments of idiosyncratic types, which constitute a potential source of monopoly, are undertaken without risk of exploitation. For the reasons and in the ways developed below, internal labor markets can have, and some do have, the requisite properties to satisfy this prescription.

2. Structural Attributes and their Efficiency consequences


A leading difficulty with individual contracting schemes where jobs are idiosyncratic is that workers are strategically situated to bargain oppor- tunistically. The internal labor market achieves a fundamental transformation by shifting to a system where wage rates are attached mainly to jobs rather than to workers. Not only is individual wage bargaining thereby discouraged, but it may even be legally foreclosed (Summers. 1969, p. 531). Once wages are expressly removed from individual bargaining, there is really no occasion for the worker to haggle over the incremental gains that are realized when adaptations of degree are proposed by the management. The incentives to behave opportunistically, which infect individual bargaining schemes, are correspondingly attenuated.

Moreover, not only are affirmative incentives lacking, but there are disincentives, of group disciplinary and promotion ladder types, which augur against resistance to authority on matters that come within the range customarily covered by the authority relation.37 Promotion ladder issues are taken up in conjunction with the discussion of ports of entry in section 4.2.4, below; consider, therefore, group disciplinary effects.

In this connection Barnard observes (1962, p. 169) :

Since the efficiency of organization is affected by the degree to which individuals assent to orders, denying the authority of an organization communication is a threat to the interests of all individuals who derive a net advantage from their connection  with the organization,  unless the orders are unacceptable to them also. Accordingly, at any given time there is among most of the contributors an active personal interest  in the maintenance  of   the authority of all orders which to them are within the zone of indifferen ce. The maintenance ol this inteiest is largely  a function of intormal organization.

The application of group pressures thus combines with promotional incentives to facilitate adaptations in the small. 12 Even individuals who have exhausted their promotional prospects can thereby be induced to comply. System interests are made more fully to prevail. This concern with viability possibly explains the position taken in labor law that that orders which are ambiguous with respect to, and perhaps even exceed, the scope of authority, are to be fulfilled first and disputed later ( Summers 1969, pp. 538. 573).


Internal labor market agreements are commonly reached through collective bargaining. Cox observes in this connection that the collective bargaining agreement should be understood as an instrument of government as well as an instrument of exchange. “The collective agreement governs complex, many-sided relations between large-numbers of people in a going concern for very substantial periods of time” (1958. p. 22). Provision for unforeseeable contingencies is made by writing the contract in general and flexible terms and supplying the parties with a special arbitration machinery. “One simply cannot spell out every detail of life in an industrial establishment, or even of that portion which both management and labor agree is a matter of mutual concern” (Cox. 1958, p. 23 K Such contractual incompleteness is an implicit concession to bounded rationality. Rather than attempt to anticipate all bridges that might conceivably be faced, which is impossibly ambitious and excessively costly, bridges are crossed as they appear.

However attractive, in bounded rationality respects, adaptive, sequential decision-making is. admitting gaps into the contract also poses hazards. Where parties are not indifferent with respect to the manner in which gaps are to be filled, fractious bargaining or litigation commonly result. It is for the purpose of forestalling the worst outcomes of this kind that the special arbitration apparatus is devised.

Important differences between commercial and labor arbitration are to be noted in this connection. For one thing, . . the commercial arbitrator finds facts — did the cloth meet the sample — while the labor arbitrator necessarily pours meaning into the general phrases and interstices of a document” (Cox, 1958, p. 23). In addition, the idiosyncratic practices of the firm and its employees also constitute “shop law” and, to the labor arbitrator, are essential background for purposes of understanding a collective agreement and interpreting its intent (Cox, 1958, p. 24).

In the language of the organizational failures framework, the creation of such a special arbitration apparatus serves to overcome information impactedness because the arbitrator is able to explore the facts in greater depth and with greater sensitivity to idiosyncratic attributes of the enterprise than could normal judicial proceedings. Furthermore, once it becomes recognized that the arbitrator is able to apprise himself of the facts in a discerning and low cost way, opportunistic misrepresentations of the data are discouraged as well.


Also of interest in relation to the above is the matter of who is entitled to activate the arbitration machinery when an individual dispute arises. Cox takes the position that (1958, p. 24)

… giving the union control over all claims arising under the collective agreement comports so much better with the functional  nature of a collective bargaining agreement. . . . Allowing an individual to carry a claim to arbitration  whenever he is dissatisfied  with the adjustment worked out by the company and the union . . . discourages the kind of day- to- day cooperation between company and union which is normally the mark of sound industrial  relations — a relationship  in which grievances are treated as problems to be solved and contracts  are only guideposts in a dynamic human relationship. When … the individua l’s claim endangers group interests, the union’s function is to resolve the competition by reaching an accommodation or striking a balance.

The practice described by Cox oi giving the union control over arbitration claims plainly permits group interests, whence the concern for system viability, to supercede individual interests, thereby curbing small numbers opportunism.


Acceding to authority on matters that fall within the zone of acceptance merely requires that employees respond in a minimally acceptable, even perfunctory way. This may be sufficient for tasks that are reasonably well- structured. In such circumstances, the zeal with which an instruction is discharged may have little effect on the outcome. As indicated, however, consummate cooperation is valued for the tasks of interest here. But how is cooperation of this more extensive sort to be realized?

A simple answer is to reward cooperative behavior by awarding incen- tive payments on a transaction-specific basis. The employment relation would then revert to a series of haggling encounters over the nature of the quid pro quo. however, and would hardly be distinguishable from a sequential spot contract. Moreover, such payments would plainly violate the nonindividualistic wage bargaining attributes of internal labor markets described in Section 4.2.1. above.

The internal promotion practices in internal labor markets are of special interest in this connection. Access to higher-level positions on internal promotion ladders are not open to all comers on an unrestricted basis. Rather, as part of the internal incentive system, higher-level positions (of the prescribed kinds)ln are filled by promotion from within whenever this is feasible. This ptactice, particularly if it is followed by other enterprises to which the workers might otherwise turn for upgrading opportunities, ties the interests of the workers to the firm in a continuing way.42 Given these ties, the worker looks to internal promotion as the principal means of improving his position.

The practice of restricting entry to lower-level jobs and promoting from within has interesting experience-rating implications. It permits firms to protect themselves against low productivity types, who might otherwise successfully represent themselves to be high productivity applicants. by bringing employees in at low level positions and then upgrading them as experience warrants. Furthermore, employees who may have been incorrectly upgraded but later have been “found out,” and hence barred from additional internal promotions, are unable to move to a new organization without penalty.43 Were unpenalized lateral moves possible, workers might, considering the problems of accurately transmitting pro- ductivity valuations between firms, be able to disguise their true productivity attributes from their new employers long enough to achieve some additional promotions. Restricting access to low level positions serves to protect the firm against exploitation by opportunistic types who would, if they could, change jobs strategically for the purpose of compounding evaluation errors between successive independent organizations.

Were it, however, that markets could perform equally well these experience-rating functions, the port of entry restrictions described would be unnecessary. The (comparative) limitations of markets in experiencerating respects, which were referred to in Chapter 2, warrant elaboration. The principal impediment to effective interfirm experience-rating is one of communication.44 By comparison with the firm, markets lack a rich and common rating language. The language problem is particularly severe where the judgments to be made are highly subjective. The advantages of hierarchy in these circumstances are especially great if those persons w ho are the most familiar with a worker’s characteristics, usually his immediate supervisor, also do the experience-rating. The need to rationalize subjective assessments that are confidently held but, by reason of bounded rationality, difficult to articulate is reduced. Put differently, interfirm experience-rating is impeded in information impactedness respects.

Reliance on internal promotion has affirmative incentive properties because workers can anticipate that differential talent and degrees of co- operativeness will be rewarded. Consequently, although the attachment of wages to jobs rather than to individuals may result in an imperfect correspondence between wages and marginal productivity at ports of entry, productivity differentials will be recognized over a time and a more perfect correspondence can be expected for higher-level assignments in the internal labor market job hierarchy.

3. Three Caveats

The above discussion is incomplete in several respects. For one thing, it does not pretend to be exhaustive in describing the structured aspects of internal labor markets. At most the more prominent features have been identified. Second, the treatment of efficiency effects has not been symmetrical. The focus has been strictly on efficiency gains, while a more complete treatment would be concerned with the net gains (and thus would consider efficiency losses as well). However, inasmuch as the efficiency gains of internal labor markets have hitherto been somewhat neglected, an affirmative statement of the ways in which the structure of internal labor markets serves to economize on bounded rationality and attenuate opportunism seems useful.

Third, the contractual atmosphere associated with individualistic and collective contracting modes differs. As compared with individualistic contracting modes, where rewards are usually contingent on performance in a transaction-specific fashion (for example, on a piece rate basis), workers in internal labor markets are metered less intensively. Recall in this connection that compensation rates in internal labor markets are assigned to jobs and that rewards are made contingent on performance through the promotion process. Accordingly, no attempt is made to settle accounts with respect to each transaction as it occurs but workers are experience-rated instead in an overall performance fashion. Also, qualification for advancement on the internal promotion ladder often turns partly on seniority (Doeringer and Piore, 1971. pp. 54-57). The resulting contractual atmosphere not only differs from but is apt to be favored by some workers over that which obtains when each transaction is monitored and the corresponding account is settled separately.

Moreover. Doeringer and Piore s remarks concerning the due process attributes of internal labor markets (1971, p. 29) suggest that there are atmospheric differences between collective and individualistic contracting in this respect as well. The internal due process machinery associated with internal labor markets is apt to be valued not only for the efficiency reasons described in Section 4.2, above, but also because a greater sense of justice (absence of whimsy or prejudice) results.

As pointed out at the outset, however, reference to atmosphere does little to explain the absence of structure for fungible jobs and the appearance of structure where jobs are idiosyncratic. Assuming that atmospheric gains of the types described would be valued for jobs of both kinds, and if it is the case that the structure needed to realize such gains appears only in conjunction with the latter, then the rationale for observed structural differences presumably lies elsewhere. An examination of the efficiency attributes of alternative contracting modes in relation to task characteristics is accordingly warranted. It is the burden of this chapter that the pairing of internal labor markets with idiosyncratic tasks is principally explained in transactional-efficiency terms.

Source: Williamson Oliver E. (1975), Markets and hierarchies: Analysis and antitrust implications, A Study in the Economics of Internal Organization, The Free Press.

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