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From a global perspective: Assessing the effects of labor market reforms

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Since the 2008/09 global recession unemployment and inequality have been on a rise. Reforms of labor markets have been one prominent feature in different countries and regions over the last years, not least in the context of the 2008/09 global recession. There has also been a continued debate in both the academia and policy circles about the effects of labor market reforms and regulation.

There are some who argue that labor market reforms and regulation have adverse effects on employment growth, increase in temporary/part-time or informal forms of employment and that it leads to higher unemployment especially among youth. However, the empirical evidence has been quite mixed and the direction remains unclear. Along with labor market reforms, a wide range of active labor market policies were also introduced in both advanced and emerging economies to get the working age people off benefits and into during the crisis. Many of these policies or programs were defined and implemented differently across countries and the extent to which they were successful also differed.

Addressing inequality has been another objective for many countries since the economic crisis. There is a renewed interest since the 2008 economic crisis on minimum wages as a useful and relevant policy tool as more and more countries experience increase in both income and wage inequality. A number of emerging and developing economies have been more active in revising the minimum wages on a regular basis. Even in advanced countries, such as Germany, the UK, and the US, minimum wages have gained importance to address income inequality.

Finally, collective bargaining is a labor market institution that has long been recognized as a key instrument for addressing inequality in general and wage inequality in particular. A number of countries across the different regions also introduced non-contributory social security schemes to provide income to the poor and to reduce inequality.

Discussing labor market reforms (from the left): Werner Eichhorst (IZA), Guy Rider (Director-General, ILO), and Moazam Mahmood (Head of ILO Research Department)

To achieve a better understanding of the effects of labor market reforms and the effectiveness of public policies, a conference was hosted jointly by the ILO and IZA in March 2016 at the ILO headquarters in Geneva (see program). Co-organized by Werner Eichhorst on behalf of IZA, the conference provided the forum for a broad debate about the design and the effects of reforms affecting labor market institutions.

From the presentations it became clear that evidence on significant positive short-run effects of flexibility-enhancing reforms, e.g. with respect to employment protection on job creation is scarce. At the same time many speakers stressed the importance of a positive macro-economic environment to realize the full positive potential of labor market reforms instead of creating more instability in the labor market.

This is particularly true for reforms expanding unemployment benefits and active labor market policies while lowering employment protection. This flexicurity approach might be desirable as it reduces the risks of persistent unemployment and provides sufficient support for job seekers (see the most recent IZA paper by Eichhorst, Marx and Wehner) – however, job finding opportunities and funding requirements depend on economic dynamism.

[Click here to watch the panel discussion video]

The twofold effect of technical progress on retirement

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Even though life expectancy is rising in most OECD countries, participation rates for older workers remain low. The fact that a non-negligible fraction of individuals exit the labor force well before retirement age has grave economic consequences, as it influences the economic dependency ratio of a country, that is, the ratio of retirees and unemployed over the employed.

Among the less noted factors that affect early retirement is technical progress. In a new research paper published in the IZA Journal of Labor Policy, Lorenzo Burlon (Bank of Italy and IZA) and Montserrat Vilalta-Bufí (University of Barcelona) reexamine the effect of technical progress on early retirement in the US. They find that technical progress affects early retirement in two opposing ways. On the one hand, it increases real wages and thus produces an incentive to postpone retirement, while on the other hand, it erodes workers’ skills, making early retirement more likely.

The researchers use US data from the Health and Retirement Study (HRS), a survey that follows about 37,000 adult individuals for 10 biennial waves between 1992 and 2010 and provides retrospective information on their job history. They merge this with individual data from US World KLEMS, a database that provides information on output, inputs and productivity at a detailed industry level. That way the authors are able to associate each individual with the technical change he or she must have faced during the period of observation. After the combination of these two datasets, Burlon and Vilalta-Bufí calculate how technical change affects the probability to retire early and compare the results to those obtained with other measures of technical change.

Probability of early retirement changes with degree of technical change

They find that the effect of technical change on the probability of early retirement changes depending on the degree of technical change. When technical change is fast, it will cause more people to retire early, because elderly workers find it difficult to adapt to the new, more technical job environment. As their skills become more and more obsolete they are more likely to retire early.

However, the authors notice that once a certain degree of technical change has been reached, the probability to retire early decreases again. They put the threshold of technical change at around 85%, above which early retirement depends negatively on technical change. They explain this with the fact that a large degree of technical change also has a large positive effect on wages. Faced with these large pecuniary incentives, workers are more likely to adapt to the new working environment, learn new skills and retire later.

Overall, the study thus reports a U-shaped relation between technical change and the probability of early retirement (see figure below). To verify their findings, the authors also performed various robustness checks and were able to exclude alternative explanatory factors.

The findings by Burlon and Vilalta-Bufí suggest that the higher the technical change, the more willing the elderly are to retrain, an insight which should be taken into account by policy makers. In the context of an aging society, the authors propose that policies should aim at delaying retirement and stimulate the participation of the elderly to the labor force.

For example, an increase in workers’ working horizon can stimulate the elderly’s labor force participation. Particularly in sectors with larger technical change, individuals are more inclined to take up training programs and delay retirement, so that training policies for the elderly become more effective.

How bad is involuntary part-time work?

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By Daniel Borowczyk-Martins (Sciences Po and IZA) and Etienne Lalé (University of Bristol and IZA)

When assessing the state of the labor market economists and policy-makers usually look at the unemployment rate. In recent years, observers have been paying increasing attention to involuntary part-time employment as an alternative and complementary measure of the amount of slack in the U.S. labor market.

The rise of involuntary part-time employment during the Great Recession was as spectacular as that of unemployment, but while unemployment has already returned to pre-crisis levels, involuntary part-time work remains stubbornly elevated several years into the recovery. Understanding the sources of the evolution of involuntary part-time employment seems key to attain a broader comprehension of labor market fluctuations, as well as their effect on workers’ welfare. In our recent IZA discussion paper we examine these two questions in detail.

Definition and comparison with unemployemt

The U.S. Bureau of Labor Statistics classifies individuals as involuntary part-time workers if they cannot find a full-time job or face slack demand conditions in their job. This definition underscores that workers in involuntary part-time employment face constraints in their desired labor supply, and establishes a useful parallel to the definition of unemployment (according to which, workers actively search for work but lack opportunities to do so).

That parallel extends to other dimensions of workers’ welfare, including income losses (and the availability of public insurance against it) and the allocation of non-market time to searching for a job or home production/leisure. Indeed, full-time workers who move to involuntary part-time experience a reduction in labor income (via a reductions in paid hours, hourly wages, or both), but, unlike those who end up unemployed, a large fraction of U.S. workers are not eligible to a public insurance mechanism to cover the associated income loss.

Cyclical dynamics

In the first part of the paper we characterize empirically the dynamic behavior of involuntary part-time employment. In a nutshell, we show that involuntary part-time employment is a remarkably transitory state and that most of workers who move in and out of that state come from or leave to full-time employment. We also document that the increase in the involuntary part-time rate observed during the Great Recession occurred by dint of a sharp increase in the probability of full-time workers to become part-time employed with their current employer.

The small duration of involuntary part-time employment spells seems to result from the dual nature of this labor market state. On the one hand, compared to unemployed workers, involuntary part-timers are much more likely to return to a voluntary form of employment in the next period. Since the pool of unemployed and involuntary part-time workers is similarly composed of workers with strong labor force attachment (male, in prime age, with low educational attainment and unmarried), this difference likely reflects labor demand factors.

The fact that transitions between involuntary part-time and full-time work occur overwhelmingly at the same employer further suggests that workers are quickly put in part-time and brought back to full-time employment while staying in the same job. On the other hand, involuntary part-time work involves a more fragile employment relationship vis-a-vis those held by voluntary part-time and full-time workers. Not only are workers in such situation more likely to quit (if given the chance), but also they are more likely to be forced out of the job into unemployment (when and if demand conditions further deteriorate).

Welfare implications

In the second part of the paper, we build on our empirical results to tackle the following question: How bad is involuntary part-time work compared to unemployment? Our tentative answer, grounded in a quantitative framework traditionally used to study the welfare costs of unemployment, is that involuntary part-time work is not as bad as unemployment from a worker’s perspective. The key aspect governing that difference is the much higher probability to return to full-time employment faced by part-time workers. In our framework unemployed workers decide on how much search effort to exert to gain access to full-time employment.

We find that, in a counterfactual world where part-time workers can only use the search technology available to the unemployed, they would need a very high level of search effort in order to mimic their actual probability to move to full-time employment. We interpret this result as a premium in access to full-time work enjoyed by part-time workers. Using our calibrated model we ascribe a welfare value to that premium of about 5% of consumption during the first quarter of a part-time work spell.

Policy views

As involuntary part-time work becomes pervasive in the U.S. labor market it is likely that related public insurance programs, such as short-time compensation schemes, will gain importance in policy debates. Our analysis focuses on the implications of involuntary part-time work at the individual level, but cannot judge its broader macroeconomic consequences. In our view, it is unclear whether public insurance targeted at involuntary part-time work would necessarily lead to gains in social welfare.

To answer that question a number of key issues need to be taken into account. First, there may be a significant degree of moral hazard regarding the number of hours worked and the voluntary/involuntary nature of a reduction in the schedules of working hours. Second, there are fundamental interactions between the risks of involuntary part-time work and unemployment, and the existence of public insurance against the latter. Future work should consider the joint design of public insurance against unemployment and involuntary part-time work taking into account the distinct dynamic behavior of the two labor market states.

In another paper , we document that fluctuations in part-time employment play a major role in movements in hours per worker in the US and UK labor markets.

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Editor’s note:
For further reading see also latest article by Andrea Garnero on IZA World of Labor:

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Countries benefit from legalizing undocumented immigrants

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A new article published on IZA World of Labor finds that legalizing illegal immigrants can boost tax revenues, prevent worker exploitation, reduce crime, and support national security.

Millions of migrants cross borders without authorization each year. The global stock of illegal immigrants has been estimated in the tens of millions, and the refugee crisis is adding to this number. Governments struggle when it comes to dealing with undocumented immigrants. Mass deportation programs violate human rights and are impractical, but legalization is contentious; many people believe that immigrants can hurt the job prospects of native-born workers and impose costs on government and society. However, in the new IZA World of Labor report, Cynthia Bansak (St. Lawrence University and IZA) presents the latest research which shows that countries ultimately benefit from legalizing immigrants.

Legalization allows undocumented immigrants greater mobility, the ability to work, access to health and social services, and equal protection under the law. Research conducted in the US and in Europe indicates that legalization often increases tax revenues, as more immigrants pay taxes or pay higher taxes when incomes rise due to their legal status. Research has also begun to document links between legalization and remittances, consumption decisions, educational investment, and criminal behavior.

To minimize costs to the receiving country, regularization programs can impose waiting periods on eligibility for certain government services. Programs could be phased in so that individuals are initially granted temporary legal status to work and reside in the host country. In a second stage, immigrants who meet specific requirements could then move on to legal permanent residency. Comprehensive legislation can bring undocumented immigrants into the mainstream and deter new unauthorized immigration.

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Turning unemployed into self-employed can be an effective alternative to traditional labor market policies

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In order to curb unemployment, OECD countries have made enormous efforts and spent considerable sums on active labor market policies (0.6% of GDP in 2011). Governments have mainly relied on traditional measures such as job creation schemes, training programs, and wage subsidies which have often shown dissatisfactory impacts on income and employment prospects of participants.

A promising alternative to traditional programs are start-up subsidies for the unemployed. This type of program supports people out of work to start their own business, thereby not only bringing these people back into work, but ideally also creating new employment opportunities for others as well. Experiences with start-up subsidies for unemployed are diverse and come from various settings. In a new IZA World of Labor article, Marco Caliendo (University of Potsdam) summarizes scientific evidence on the effectiveness of start-up subsidies in industrialized countries and highlights consequences for policy design.

Start-up subsidies improve labor market outcomes

After reviewing studies from OECD countries, Caliendo concludes that start-up subsidies are an effective active labor market policy that can help participants escape unemployment, increase their human capital and improve their future labor market prospects. Even if the business has failed, program participants’ chances on the labor market are still comparably better than those of other unemployed workers. The positive effects of subsidized start-ups may be even higher for disadvantaged groups, such as women, youth, and low-educated workers.

But subsidies also induce a potential negative bias: On average publicly supported start-ups out of unemployment show weaker business performance and spur less business growth and innovation than other start-ups. However, if policymakers’ main goal is to re-integrate unemployed workers into the labor market, they can neglect weaker business performance. If policymakers seek to establish solid new businesses with strong growth rates and job-creation potential, start-up subsidies for the unemployed might not be the best choice.

As Caliendo shows, recent research identifies several elements of start-up programs for unemployed that contribute to their overall success. The time horizon of the subsidy should be neither too short, in order to allow time to overcome initial problems, nor too long, to avoid moral hazard. To help participants survive the initial stage of self-employment when the business might not yield an adequate income, the financial component should cover basic living costs and social security contributions.

Screening, coaching and mentoring are crucial

Initial screening, including the creation of a credible business plan that is approved by an objective third party, is a further crucial element of success. The screening process has to be sufficiently stringent to prevent windfall gains and to ensure that only those people who are truly interested in starting a business take part in the program.

When these caveats are accounted for, start-up subsidies may have the potential to offer a “double dividend”: they can create not only jobs for the founder but also for further potential employees. In addition, subsidizing start-ups can have a positive impact on structural change, innovation, and technology diffusion. In the end, the success of the program depends on the question if the newly self-employed are able to establish solid business growth. Therefore, program subsidies should also be accompanied by support services, such as coaching and mentoring, which can help develop new businesses and support ambitious entrepreneurs who want to enlarge their business operations.

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Economic long-term outlooks often too pessimistic

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Demographic aging and accompanying shrinking labor forces are common phenomena throughout the developed world. There is a widespread notion that societal aging will put significant pressure on public budgets, a view supported by recent OECD projections. Expenditures for public health are expected to rise, old-age pension systems already are burdened by an imbalance of working and retired population shares. This may threaten governments’ capacities to fund social welfare systems and the provision of other vital public goods, like education or infrastructure.

Such pessimistic outlooks often neglect possible developments on the revenue side of governments’ budgets, and ignore important interrelations between demographic transitions and labor market outcomes. If, for example, a shrinking labor force is becoming better educated at the same time, average wages might increase. Additionally, if there is a scarcity of labor, standard economic theory predicts that wages should increase in order to stimulate labor supply. Future tax revenues may therefore increase despite population shrinkage.

To overcome these limitations to provide a more appropriate outlook, IZA CEO Hilmar Schneider, IZA Fellows Mathias Dolls (ZEW, IZA), Karina Doorley (CEPS, IZA), Alari Paulus (U Essex), Sebastian Siegloch (U Mannheim, IZA), and Eric Sommer (IZA) study fiscal sustainability in the EU by combining population projections for 2030 with micro-based elasticities of labor supply and demand. They consider two demographic projection scenarios, one pessimistic and one optimistic, which differ in the degree of immigration that counteracts against an aging population.

As a key contribution of this study, the authors explicitly model implied wage effects of these demographic projections under consideration of supply and demand elasticities. Supply elasticities (the degree to which an individual adjusts his or her labor supply to changing wage rates) are obtained from Bargain et al (2014) and are differentiated by skill, gender and household type for each EU country. On the demand side, they differentiate own-wage elasticities of demand (firms’ labor demand responses to wage rate changes) by country and skill group, drawing on the meta-analysis by Lichter et al (2015).

Using this setup, the authors are able to estimate the fiscal consequences of the demographic pressure on the balance between sources of public revenue (i.e. personal taxes, social insurance contributions, social transfers, and public pensions) and demography-related expenditures (i.e. health, old-age care, child care, and educational expenditures) and to analyze the impact of an increase in the statutory retirement age, an obvious and widely discussed policy response to demographic change.

The results of the study are striking. Irrespective the pessimistic or optimistic scenario, there are two mega-trends for the future European labor force. While becoming older, EU labor forces are projected to become better educated at the same time (Figure 1), with the consequence of rising average wages throughout Europe.

Figure 1

These changes in size and education of the work force have important fiscal consequences. Figure 2 depicts changes in the fiscal balance from 2010 to 2030 decomposed into effects on direct taxes (TAX), social insurance contributions by employers, employees and self-employed (SIC), social transfers and pensions (BEN), as well as other age-related public expenditures for education, child care and health (EXP) [1].

Figure 2

Descriptive results differ greatly by whether wage reactions to demographic pressure are taken into account. Pure demographic effects, ignoring labor market effects (left bar in each country), predict expenditures to grow, and draw fiscal balances below zero (the orange dots represent overall balances). This outcome is however unrealistic, as it does not account for labor market changes as a consequence of changing scarcities on the labor market, i.e. raising wages and tax revenues. If wage reactions are taken into account (middle bar), higher revenues from taxes and contributions drive total balances towards or even above zero, while benefit payments remain rather unchanged. This suggests that ignoring labor market feedbacks with demographic change may lead to fiscal conclusions that are too pessimistic.

Finally, assuming an increase in the statutory retirement age as a likely policy response (in this case uniformly by 5 years between 2010 and 2030), this reform would further improve fiscal balances in the majority of countries, due to lower benefit payments and higher income tax revenues. There is however an attenuating effect, as the UK example demonstrates. While a higher retirement age increases the number of people in work, this may have detrimental effects on average wages, manifesting in lower total revenues. This simple experiment of a substantial increase in the statutory retirement age however shows that, taking labor market effects into account, this may bring fiscal balances close to zero in most EU countries.

In the case of Germany the fiscal balance stays below zero, even after labor market effects and a higher retirement age have been taken into account. This is largely due to the fact that overall population and labor force recede stronger in Germany than in most other European countries. In addition the authors assume only a weak German educational expansion, which leads to weaker positive fiscal effects. But as Figure 2 shows, even the German fiscal balance is much less pessimistic once labor market effects and a higher retirement age are considered.

“Overall, the results paint a less worrying outlook on the fiscal implications of the demographic change. Wage dynamics are highly relevant for the analysis as dramatic demographic shifts may engender important wage adjustments. This highlights the importance of taking interactions between the demand and supply sides of the labor market into account when evaluating retirement reforms – it can be highly misleading to look at static effects only,” says IZA’s CEO Hilmar Schneider.

[1] Figure 2 is based on figure 7 in the IZA Discussion Paper (Dolls et al. (2015): Fiscal Sustainability and Demographic Change: A Micro Approach for 27 EU Countries. IZA Discussion Paper 9618. December 2015.)
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How (lack of) sleep affects our economic behavior

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Today is World Sleep Day! As recent IZA research shows, a good night of sleep is not just a matter of individual well-being but has wider implications for social behavior and economic outcomes. So we suggest you get yourself a big cup of coffee and have a look at some of these findings that may lead you to think differently about your own sleep routines.

Sleep, trust and risk preferences

Economists examine the rational behavior of people (and deviations from it). Rational behavior requires people to be awake so they can tap their cognitive resources. A number of studies published in the IZA discussion paper series shows that insufficient sleep indeed decreases the performance of individuals even in simple tasks.

In a recent IZA discussion paper, David L. Dickinson (Appalachian State University and IZA) and Todd McElroy (Florida Gulf Coast University) analyze the effect of sleep deprivation on interpersonal trust in a controlled lab experiment. 184 test subjects were assigned different sleep schedules over a span of 3 weeks – either a 5-6 hours restricted sleep or an 8-9 hours well-rested schedule. Additionally, the researchers validated the test subjects according to their “circadian rhythm”, i.e. whether they were rather a morning or an evening type. The test subjects were then randomly assigned to either early morning, late evening and intermediate test sessions. In these test sessions, they had to play “trust games” which were used to elicit their contemporary level of interpersonal trust.

The result: Sleepiness, either induced through sleep restriction or through “circadian mismatches” (an evening type forced to play games in the early morning) significantly reduced levels of interpersonal trust, which is known to be a prerequisite for prosocial behavior.

In a related experiment, Dickinson teamed up with Marco Castillo and Ragan Petrie from George Mason University to examine how sleep deprivation, again induced through circadian mismatches, affects choice consistency and risk preferences in simple risky choice games. Experimentally-induced sleep deprivation was shown to significantly alter the risk preference of the players, with sleepy players displaying a larger willingness to take risks.

Sleep, cognitive skills and health

Going beyond the lab in their new IZA discussion paper, Oxford University researchers Osea Giuntella and Wei Han with Fabrizio Mazzonna (Università della Svizzera italiana) show that this relationship between sleep deprivation and cognitive skills also holds in a large health survey, the Chinese Health and Retirement Longitudinal Study. They exploit a quasi-experiment by using differences in sunset.

The idea: Due to circadian rhythms, the human body reacts to environmental light producing more melatonin when darker. Thus, when sunset occurs at a later hour, individuals tend to go to bed later. Because of the geographically broad single standard time zone of China, there are large differences in both sunrise and sunset time between cities, which the researchers can use to assess the effect of sleep on cognitive outcomes.

Increasing sleeping time by one hour significantly increases the scores reported in cognitive tests measuring mental and numerical skills: A one-hour change in sleep duration produces effects on cognitive outcomes ranging from 0.4 to 0.6 standard deviations, a result that is primarily driven by rigid working schedules of the urban population.

In a related study, Guintella and Mazzonna conduct a similar quasi-experiment using the broad time zone of the US to assess the effects of insufficient sleep on general health status and obesity. Again, comparing individuals living on the eastern side of a time zone who go to bed later than comparable individuals living on the opposite border (while working schedules do not account for differences in sunset), they find that sleep deprivation increases the likelihood of reporting poor health status and the incidence of obesity.

The authors conclude that many individuals suffer from a misalignment between social and biological time. Behaviors like eating late, exercising less and dining out contribute to these effects of sleep deprivation on health.

This effect of sleep on health is in part complemented by an IZA discussion paper by Cornell University researchers Lawrence Jin and Nicolas R. Ziebarth, who assess the health effects of daylight saving time using a large data set on hospital admissions in Germany and the US. Their finding shows virtually no effect of “springing forward” in time by one hour in spring.

Contrarily, though, they find an increased share of people reporting excellent health and a sharp decrease of about 8 hospital admissions per 100,000 population on days 1 to 4 after “falling back” one hour in fall, which indicates that sleep may lead to significant, immediate health improvements for people on the margin to getting hospitalized.

Sleep and education

Getting up early to go to school may be the most commonly experienced situation in which the effect of sleep deprivation becomes apparent. It is thus not surprising that sleep deprivation in the educational context has received large attention among researchers. Teny Maghakian Shapiro (Santa Clara University) summarizes the growing literature on the effect of school start times on educational performance in a recent IZA World of Labor article.

The combination of changing sleep patterns in adolescence and early school start times leaves secondary school classrooms filled with sleep-deprived students. Evidence is growing that allowing adolescents to start school later in the morning improves grades and emotional well-being, and even reduces car accidents.

Opponents cite costly adjustments to bussing schedules and decreased time after school for jobs, sports, or other activities as reasons to retain the status quo. In sum, however, the IZA World of Labor article suggests that changing school start times is one of the easiest to implement and least expensive ways of improving academic achievement.

Sleep and the labor market

While it is likely that this negative impact of sleep deprivation also affects individual performance on the job, Christian Pfeifer (Leuphana University Lüneburg and IZA) takes a different perspective on the relationship between labor markets and sleep.

According to his recent IZA discussion paper, working conditions significantly affect sleep quality. More specifically, he shows that employees who perceive their wage as inappropriate or unfair have a 10 percent lower probability to report a “normal” length of sleep (8-9 hours) and a 36 percent higher chance of being diagnosed with sleep disorders.

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Why do many European graduates end up in lower-paid jobs?

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Skill mismatch has become an issue of increasing policy concern in the aftermath of the economic crisis, which saw high levels of youth unemployment in the EU economy. Weak labor demand, combined with rising levels of higher education attainment, have increased overeducation rates in many advanced European economies.

Overeducation by population groups

However, the policy debate about the underlying causes and significance of the phenomenon of overeducation is yet unresolved. Part of the wage penalty of overeducated university graduates can be attributed to their lower levels of work experience and training, while mismatch is also naturally higher for young workers at the early stages of their careers.

A new IZA discussion paper by Seamus McGuinness and Konstantinos Pouliakas uses Cedefop European skills and jobs survey data to examine previously unavailable demand-side characteristics, such as the level of skill demand in employees’ jobs.

Using a representative sample of adult employees from 28 EU countries, the analysis shows that job characteristics and the low skill content of their jobs account for an equal share of the wage penalty of overeducated workers as supply-side factors.

Lack of information about skill needs and career prospects of jobs is also an important reason why overeducated tertiary graduates end up in lower-paid jobs. The paper thus highlights that policies that emphasize career guidance and counseling and those that seek to raise job quality can be effective ingredients in mitigating overeducation in European labor markets.

Should firms fill vacancies with own workers or outside hires?

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Recruitment is one of the most important decisions businesses face. To ensure productivity and profitability remains high it is crucial that the right people are in the right roles within the company. However, there is an important decision to make when recruiting new personnel: Should you recruit internally from existing company talent, or look for an injection of new ideas and skills from external candidates?

Jed DeVaro writes—in his new IZA World of Labor article Internal hiring or external recruitment?—that “Internal hiring should be preferred to external hiring when knowledge and skills specific to the firm are important, when promotions are crucial for motivating current workers, and when the costs of a hiring mistake are particularly large.”

However, internal hiring decisions should be made carefully and consider the implications for employees elsewhere in the job ladder, particularly at the lower levels. This chance to rise within the ranks of a company may have positive effects on the motivation of more junior employees, but promoting from within can then create a chain of job vacancies to fill, with the added costs of recruiting for multiple positions.

External hiring is beneficial as it increases the pool of applicants which may increase firm success in the long run by bringing someone with a different perspective and skill-set into the team. The option of recruiting someone from outside of the business could also discourage employee complacency due to the expectation of promotion once jobs become available up the ladder.

New forms of work and shady employers: How reputation can discipline the “gig economy”

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Uber, Airbnb, TaskRabbit, and other online platforms have drastically reduced the price of micro-contracting and grown a “gig” economy, where workers must more frequently decide which potential employers to trust. Traditionally, workers have used labor unions and professional associations as a venue for exchanging information about working conditions and coordinating collective withdrawal of trade in order to discipline employers.

The rise of new institutions that facilitate information sharing may take up some of this role, a recent IZA discussion paper by Alan Benson, Aaron Sojourner and Akhmed Umyarov (all University of Minnesota) suggests. In two experiments in an online labor market (Amazon’s Mechanical Turk or M-Turk), the authors show that a public, employer-reputation system has value for:

  1. workers who use it to screen potential employers on otherwise unobservable differences, and
  2. employers who can benefit when a better reputation makes it easier to attract more workers of any given quality, basically shifting out the labor supply curve they face.

The experiments provide the first estimates of the value of employer reputation measured outside the lab based on any design more credible than a control function and highlight the under-appreciated struggles workers face in navigating the labor market.

The first experiment tests the validity of the reputations from the perspective of a worker. The researchers act as a worker to assess whether other workers’ public ratings reflect real variation in employer quality. One research assistant (RA) randomly selects tasks from employers who have good reputations, bad reputations, or no reputation and sends them to a second RA who is blind to employers’ reputations. Benson, Sojourner and Umyarov find that, holding work effort fixed, effective wages while working for good-reputation employers is 40 percent greater than effective wages while working for bad-reputation employers.

Employers with bad reputation must post 200% higher wages

The second experiment measures how employers’ reputations affects their ability to recruit workers. We create multiple employers on M-Turk with varying reputations and, holding all else fixed, measure differences in the rate at which they attract workers to posted jobs. Good-reputation employers attract workers about 50 percent more quickly than our otherwise-identical no-reputation employers and 100 percent more quickly than bad-reputation employers. Average quality of work does not differ. This implies employers with better reputations can operate at a faster pace, a larger scale, or be more selective in hiring. Existing estimates of M-Turk wage elasticities imply that posted wages would need to be almost 200 percent greater for bad-reputation employers to attract workers at the same rate as good-reputation employers do.

Most models of the labor market assume workers have perfect information about employer differences and gloss over the difficulty workers face in navigating these matters. The authors of the IZA Discussion Paper propose a simple, equilibrium-search model consistent with their results. Informed-type workers screen employers with bad reputations, and the threat of losing a good reputation and thus losing informed workers discourages employers from engaging in wage theft and other forms of opportunism. In this way, employers’ reputation serves as collateral against wage theft, effectively substituting for the role that formal contracts normally play in the labor market.

Overcoming the information problem

What relevance does this have for labor markets broadly? All workers strive to distinguish which employers will treat them well or ill. Two prospective employers that offer identical employment contracts may actually differ widely in the criteria they apply for raises, promotions, terminations, scheduling, bonuses, task assignment, and many other working and payment conditions. In contingent, undocumented, and low-wage labor markets, concerns are as basic as whether employers will pay for all hours worked or pay at all.

Workers have always made decisions with partial information about employer quality and, so, these forces have always shaped labor markets. Falling communications costs have made it easier for workers to share information and several websites now enable this exchange, including Glassdoor, Turkopticon, Contratados, Kununu, JobeeHive, TheJobCrowd, and the Freelancers Union’s Client Scorecard. Attention to the worker’s information problem suggests innovative directions for policy and institution-building.

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