II What Is Personnel ?

About a half-century ago, business analysis and education was highly descriptive. It focused on institution detail, it lacked unifying themes, and generally ignored frameworks that used the scientific method, where refutable hypotheses are presented and tested. In subsequent decades, the business curriculum was transformed. It became much more rigorous, but for the most part still maintained its connection with the real world, where normative instruction is as important as positive description. Modern finance is perhaps the best example of a successful evolution of thought, but other fields, such as marketing using the tools of standard theory, accounting with its use of , and business strategy, which incorporated and more traditional , have also enjoyed significant advances over the past twenty to thirty years. Personnel economics is among the fields that stands out as one that has changed the thinking in a primarily business-oriented topic, namely the management of people. Since the typical business spends between sixty and seventy percent of its resources on labor, under- standing the human part of business is of paramount importance. But for the most part, business leaders paid lip to the importance of human resources management but rarely treated the questions posed by the field and subsequent analyses with much respect. The growth of personnel economics has begun to change this picture. Personnel eco- nomics not only draws heavily on modern economics and statistical methods, it does so in a way that is useful in both describing behavior and providing a reliable set of prescriptions for businesses to follow. My own involvement in personnel economics came when, in 1978, I moved from the Economics Department at the University of Chicago to that university’s Graduate School of Business, and then later to Stanford’s business school. My students, many of whom would later become important actors in business throughout the world, found the traditional labor economics topics that I was teach-

8 What Is Personnel Economics? ing to be lacking in relevance to their world. Issues involving labor , public policy analysis, and even investment in education, unemployment, and other policy relevant aspects of labor studies, while intellectually interesting, were not particularly germane to their careers. They needed tools that would help guide them as they managed the people in their organizations. They also needed to understand methods that would allow them to do this in ways that made both firms and workers better off. Were they to ignore the latter, they would find themselves losing exactly the re- sources necessary to get the job done. The confrontation with the reality that what I was teaching was not relevant to most of my students forced me to change the focus of my research. But I was unwilling to relinquish the discipline provid- ed by economic theory and . Economics is powerful precisely because it concentrates on the important and strips away the extraneous. Its parsimonious structure, coupled with its formal approach, is a major guide to clarity of thought. I have never given up my attachment to economic theory, statistics, and their method- ology. Instead, I have used them to answer questions that were, until that point, generally deemed to be outside the realm of economic analysis. But far from being non-economic, the issues that were the central focus of human resources could be informed by economics, and the approach, which was new to that set of issues, made rapid progress in changing the field. So what is personnel economics?1 Personnel economics is defined as the application of microeconomic principles to human resources issues that are of concern to most businesses. The field arose for three primary reasons. First, as already mentioned, those of us who were teaching standard labor economics to business students encountered an uninterested audience. Their boredom with what we had to sell signaled that a change in the product might be warranted. Second, the issues studied by human resources specialists were of interest to , but the approach taken by the non- was un- satisfying to those with formal training. The field of human resources management was too loose, unfocused, ad hoc, for our tastes. It lacked the general, rigorous framework to which economists have grown ac- customed. Third, the technology of economics changed. As a result of some breakthroughs, particularly those dealing with agency and contract theory, economists were better equipped to tackle problems that had evaded them in the past.2

9 What Is Personnel Economics?

Personnel economics is an attempt to look inside the black box. It is an imperialistic attempt by economists to do what (1890) said that “economists do not do.” Personnel economists are more willing to reject Marshall’s famous statement that it is not the economist’s business to tell the brewer how to brew beer. Although personnel economists may not be the best brewmeisters, they have made progress using the tools of economics to understand and some- times even to guide practitioners and consultants in hiring, motivat- ing, and managing labor. And personnel economics is real. Personnel economics is not an intellectual exercise. It is useful in helping us to understand actual behavior in the real world.

Personnel Economics or Personnel?

Like other subfields of economics, personnel economics differs from other social sciences in three ways. First, personnel econom- ics assumes that the worker and the firm are rational maximiz- ing agents. Constrained maximization is the basic building block of the theory that forms the foundation of personnel economics. Even when evidence suggests that the theories are wrong, the per- sonnel economist does not drop the assumption of maximization. Instead, the approach is to think more carefully about the nature of the model set up, but not about the rationality of the individu- als making the choices. Some may view this as an ostrich-like de- fect. I do not. When data refute a theory, it is necessary to rethink the theory, its specifications, its assumptions, what it includes and what it leaves out. It is not a call to reject the elegance and power of maximization. The economic approach allows for imperfect information, transaction costs, and other intervening variables which make things somewhat more complicated, but the essence of personnel economics is to assume that behavior is determined primarily by the interaction of the agents and not by forces beyond their control. The success of personnel economics is in large part a result of simply assuming maximization because doing so allows the analyst to express complicated concepts in relatively simple, al- beit sometimes abstract, terms. The language of economics allows the personnel economist to remove complexity. Details may add to the richness of the description, but the details also prevent the re- searcher from seeing what is essential.

10 What Is Personnel Economics?

In many respects, this is personnel economics’ main selling point. The typical human resources text is verbose and short on general prin- ciple. Indeed, many books eschew generalization, arguing that each situation is different. The economist’s approach is the opposite. Rather than thinking of each human resources event as separate, the scientific method that economists use places a premium on finding the underly- ing general principle and on downplaying other factors. The second feature that distinguishes personnel economics from other forms of human resource analysis is that personnel econo- mists focus on equilibrium. Like the physical sciences, almost all theories in personnel economics are consistent with some notion of equilibrium. For example, workers in firms are assumed to react in a particular way where each side generally takes the actions of the others into account. When this is done, a particular equilibri- um results which, again, assists in making very specific predictions about outcomes in the real world. As obvious as this may seem, the restrictions implied by requiring equilibrium are an important and unique feature of the economic approach not only to human re- sources, but to social science in general. Equilibrium is not central to psychology, because there the subject is the individual, and not how the behavior of many individuals combine to form a system. Sociology, which does study systems, tends to do so absent any for- mal notion of equilibrium. And certainly in human resources man- agement, equilibrium is an unmentioned concept. Third, efficiency is a central concept of personnel economics. ’s early notion of the invisible hand makes its way into personnel economics. Individuals who maximize their own utility and interact with firms that maximize profits generate behavior that usually makes both parties better off. When efficiency suffers, say, as a result of problems that arise in the agency literature, the economist pushes the analysis to another level, asking what ac- tions might firms and/or workers take to alleviate such inefficiency. Taking this further step assists in making better positive predictions and also normative prescriptions for the business student. Much of personnel economics is quite consistent with traditional labor economics. Agency theory concentrates on inducing workers to put forth effort and bears a very close resemblance to the theory of labor supply. There are two differences. First, labor supply usu- ally refers to hours of work or the proportion of the population that is in the labor force. In the case of personnel economics, much of

11 What Is Personnel Economics? the discussion is about effort. Hours worked is merely one metric of effort. Second, because effort is a central variable, the inability to observe effort is at the heart of much of the discussion. The tension between the interests of the workers and the firm, although present in the study of labor supply, is more problematic when effort is con- sidered because firms cannot simply pay on the basis of observable input or . Personnel economics differs from other forms of human resource analysis in that, as in all branches of economics, there is no free lunch. Firms hire workers in a competitive labor and cannot simply take advantage of them. Workers cannot be induced to do things that they do not want to do without appropriate compensation, either in the form of money or some other non-monetary reward. But, unlike other fields that analyze workers at the level of the firm, personnel economics is willing to express all compensation in terms of money, even if money is not the only or most important factor in compensa- tion. Non-monetary factors can be expressed in terms of money sim- ply by finding its monetary equivalent through a standard hedonic approach.3 In an analogous vein, personnel economists think in terms of sub- stitution, where other human resources specialists do not. For exam- ple, most firms have a benefits department that is distinct from the compensation department. Compensation is defined specifically to include monetary remuneration only and to exclude benefits. There is no explicit recognition of trade-offs, and non-economists frequent- ly think in terms of providing some market level of each job attribute rather than thinking in terms of a total package of utility.

Personnel Economics Is Useful

Personnel economics must be judged by its ability to be used. Use must be defined in two ways. First, the field should be an effective descrip- tive device. It should provide positive analyses that provide testable hy- potheses that are both not obvious and explain the real world. Second, the field should be helpful in assisting managers to think through their human resources strategies, for hiring, motivating, and training an ef- fective workforce. I will argue that personnel economics has succeeded on both counts and will do so by summarizing some of my own work in the area, which is the subject of this book.

12 What Is Personnel Economics?

The structure is to consider four distinct aspects of personnel eco- nomics. First, personnel economics attempted to explain the exis- tence of institutions that appeared puzzling on first blush. The exis- tence of mandatory retirement, the structure of pension payments, the use of worker-firm decision making, and some apparently bizarre promotion practices all fit into this section. Second, much of personnel economics examines particular aspects of compensation. Workers are sometimes paid straight salaries, some- times given bonuses, sometimes motivated through raises and pro- motion, and sometimes rewarded with non-monetary compensation in lieu of monetary payments. To what extent and when should these various methods be used? Third, personnel economics does not ignore the interaction be- tween workers. Peer effects and social interactions form an important part of the subject. To be sure, this is one of the newer and least docu- mented aspects of the field, but a couple of examples of the frame- work and the use thereof are provided in this book. Finally, skill formation is a major factor in the workplace, both be- fore the worker joins the firm, through formal education, and after, through on-the-job training. Although this book is not about hu- man capital per se, the acquisition of , the choice of skills to acquire, and the interaction of those skills with occupation and industry structure are important parts of personnel economics. The chapters that comprise each part of the book are what I believe to have been my most significant contributions to that particular area. The chapters are very close to the original papers to preserve the historical context. References are not updated to include more recent work that extends, derives from, or criticizes the original articles. Because a substantial body of literature has emerged in the field of personnel economics, I conclude the book by summarizing some of these more significant developments and recent work. I also discuss the impact that personnel economics has had on the study of busi- ness and especially the labor component of business operations.

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