Internal labor markets and worker rents

We show that establishing an internal labor market by offering combined contracts across hierarchy levels strictly dominates external recruitment when workers are homogeneous. The reason is that only an internal labor market can exploit higher tier rents for incentive provision on lower tiers. Given unobservable heterogeneity of workers, relying on an internal labor market has the further advantage of improving the selection of high ability workers for higher ranks, which is complemented by rent-based incentive schemes. However, observable worker heterogeneity gives rise to a trade-off between incentive and selection issues and may lead to ports of entry on higher tiers of the hierarchy.

► We show that an internal labor market (ILM) is an effective instrument for utilizing worker rents to improve incentives.
► With unobservable worker heterogeneity, an ILM further improves the selection of high ability workers for higher ranks.
► However, observable worker heterogeneity may lead to ports of entry on higher tiers.