That firms employ internal labor markets, in which wages and careers are partly shielded from the vagaries of external labor markets, seems well accepted. Yet, Peter Doeringer and Michael Piore's (1985) seminal work on internal labor markets has had a rather limited impact on the economics profession. In contrast to textbooks on human-resource management, which have adopted their paradigm wholeheartedly, labor economics texts tend to pay only cursory attention to internal labor markets. The competitive model, in which wages reflect an individual's marginal product, remains the paradigm of choice. There are many reasons for this lackluster reception, including intellectual convenience. A more acceptable excuse is that while Doeringer and Piore's study, which was based on interviews with 75 companies, identified several key regularities (ports of entry, career ladders, etc.) that have come to shape our perception of internal labor markets, the book never presented a theory to explain these findings. With the advent of information economics and contract theory, models of internal labor markets-or at least selected features of these markets-have begun to emerge. The objective of these theories is to show that internal-labor-market outcomes can be construed as second-best solutions to contracting problems under incomplete information. For instance, tournament theory (Edward Lazear and Sherwin Rosen, 1981) sees the attachment of wages to jobs as part of an efficient incentive scheme. Michael Waldman (1984) explains the same phenomenon as an insurance arrangement against variations in individual productivity. Seniority rules in promotion and wagesetting can be understood as responses to problems of collusion or influence activities (Paul Milgrom and John Roberts, 1988). The list could be extended. At this point, there is hardly any feature of internal labor markets that cannot be given some logical explanation using the right combination of uncertainty, asymmetric information and opportunism. Doeringer and Piore (1985), in the preface to the second printing of their book, take exception with this line of theoretical research. They believe that internal labor markets are inherently a social (group) phenomenon and that something fundamental is missed by pursuing individualistic models. Be that as it may, we think there is another, more serious problem with the direction that this research has taken: too much of it relies on the old empirical stereotype. The original study was done 25 years ago and focused almost exclusively on blue-collar, male, unionized, manufacturing workers. One might rightly wonder how relevant these findings are in today's environment and whether they extend to white-collar work as most discussions seem to assume. Before proceeding with the theory, it is prudent to ask: do we have the facts right? In this paper we report on two recent case studies of individual firms that use personnel records to analyze wage and career paths of managerial workers: Lazear (1992) and Baker et al. (1994a,b).1 Person-

We develop a model that clarifies how to measure CEO incentive strength and how to reconcile the enormous differences in pay sensitivities between executives in large and small firms. The crucial parameter is shown to be the elasticity of CEO productivity with respect to firm size. We find that CEO marginal products rise significantly with firm size (confirming Rosen's conjecture that CEOs of large firms have a "chain letter" effect on firm performance), and overall CEO incentives are roughly constant, or decline slightly, with firm size. We employ a multitask model to discuss implications for the design of control systems.

This study documents the organizational changes that took place at the O.M. Scott & Sons Company in response to its leveraged buyout. Our findings confirm that both the pressure of servicing a heavy debt load and management equity ownership lead to improved performance. Equally important at Scott, however, and undocumented in large-sample studies, are debt covenants restricting how the cash required for debt payments can be generated, the adoption of a strong incentive compensation plan, a reorganization and decentralization of decision making, and the relationship between managers, the leveraged buyout sponsors, and the board of directors.

Explaining patterns of asset ownership is a central goal of both organizational economics and industrial organization. We develop a model of asset ownership in trucking, which we test by examining how the adoption of different classes of on-board computers (OBCs) between 1987 and 1997 influenced whether shippers use their own trucks for hauls or contract with for-hire carriers. We find that OBCs' incentive-improving features pushed hauls toward private carriage, but their resource-allocation-improving features pushed them toward for-hire carriage. We conclude that ownership patterns in trucking reflect the importance of both incomplete contracts and of job design and measurement issues.

Empirical Strategies in Contract Economics: Information and the Boundary of the Firm by George Baker and Thomas N. Hubbard. Published in volume 91, issue 2, pages 189-194 of American Economic Review, May 2001

Academics, consultants, and practitioners have long advocated bringing the market inside the firm. For example, in the 1950s and 1960s economists proposed that the transfer-pricing problem should be solved by charging market prices for internal transactions. Similarly, in the 1980s, financial economists suggested that the capital-allocation problem should be solved by charging the external cost of capital for internal investments. And wave after wave of organizational restructuring has advocated radical decentralization, empowerment, “intrapreneurship, ” and the like—in short, making employees feel like owners. Proponents of making transactions within firms more market-like often seem to ignore the factors that brought these transactions inside firms in the first place. But Bengt Holmstrom and Paul Milgrom (1991, 1994), Holmstrom and Jean Tirole (1991), and Holmstrom (1999) [hereafter collectively HMT] remind us that in some cases integration is efficient precisely because it eliminates market incentives. In such cases, bringing the market inside the firm would clearly be undesirable. In this paper we show that bringing the market inside the firm is often not feasible, even if it would be desirable. More precisely, if some aspects of the market transaction are non-contractible (as we define below) then it is impossible to replicate spot-market payoffs inside a firm. This result would be trivial if the firm’s only instruments were court-enforceable contracts: it is impossible (by definition) for such contracts to replicate payoffs that were non-contractible in a spot market. Our

A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory—including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion-based incentive systems, the absence of up-front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic—focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.

A thorough understanding of internal incentive structures is critical to developing a viable theory of the firm, since these incentives determine to a large extent how individuals inside an organization behave. Many common features of organizational incentive systems are not easily explained by traditional economic theory—including egalitarian pay systems in which compensation is largely independent of performance, the overwhelming use of promotion‐based incentive systems, the absence of up‐front fees for jobs and effective bonding contracts, and the general reluctance of employers to fire, penalize, or give poor performance evaluations to employees. Typical explanations for these practices offered by behaviorists and practitioners are distinctly uneconomic—focusing on notions such as fairness, equity, morale, trust, social responsibility, and culture. The challenge to economists is to provide viable economic explanations for these practices or to integrate these alternative notions into the traditional economic model.