Appendix B: The Intellectual Foundations of the new Science


The new science of human capital management presented in this book has been made possible by three major developments: (1) advances in knowledge about human capital and its links to organizational performance derived from burgeoning academic research primarily in economics and organizational psychology as well as documented field experience, (2) the emergence of modern electronic information systems that make employee data and all forms of financial, operational, and customer data readily accessible for real-time analysis and tracking, and (3) advances in and technological applications of modern statistical methods that allow practitioners and researchers to tap those data far more quickly and effectively to inform decision making. When these factors come together, organizations have the capacity as never before to manage their human capital investments from a strong factual platform. This appendix provides an overview of the intellectual heritage on which our work is built and the core statistical methods behind the analytic tools we present.

Research in Economics

The approach and methods presented in this book draw extensively on research in the fields of labor and organizational economics. Traditional labor economics actually had little to say about human capital management in organizations. As a branch of microeconomics it was concerned primarily with market transactions, specifically with the way labor markets operate to generate and balance the supply of and demand for labor and determine wages and salaries. However, over time two critical insights led to a transformation of labor economics. The first was recognition that human capital is not just an input to production as is stipulated in standard production theory. It is also the output of a production process in which individuals and/or organizations invest time and resources to enhance the quality and capability of labor. Hence, it follows that economic analysis could be applied to understand that process better and determine the causes and consequences of investments in human capital. It was this idea that gave rise to human capital theory and a large body of empirical research to test its key propositions.

The second insight stemmed from the observation that many of the most critical transactions involving human capital actually take place inside organizations, not in external labor markets. The employment relationship is complex and varied. One observes in practice a wide variety of contractual arrangements governing the terms of employment—some explicit, some implicit—and sometimes nonmarket mechanisms such as administrative procedures and policies play the central role. However, those nonmarket institutions accomplish the same things that external labor markets achieve: They allocate people to tasks and jobs, price those jobs and the associated labor inputs, and deliver incentives for people to develop and supply the requisite quantity and quality of labor. This suggests that the same optimization framework used to explain market relationships might be applied productively to analyzing those transactions within the firm. These insights led to a new field of investigation focusing on the employment relationship and the internal workings of the firm. In its most modern incarnation this field is called the “new economics of personnel” (Lazear, 1995).[1]

Below, we briefly characterize each of those fields and its contributions to the new science.

Human Capital Theory

Broadly speaking, human capital theory is concerned with the causes and consequences of investments in human capital both for the individual employee and for employers. The original work on human capital, beginning with the seminal studies of Jacob Mincer (1958), Theodore Schultz (1963), and Gary Becker (1964),[2] examined the economics of decisions by individuals (and by extension firms) to increase the quality of labor through expenditures on education, training, and on-the-job learning. It was recognized that both individuals and organizations incur current costs to improve labor quality that generate future returns in the form of enhanced productivity and earnings (pay and pay growth). Thus, these decisions are in essence investment decisions and can be treated in much the same way in which capital investment is modeled by financial economists. That is, economic agents, acting rationally to optimize their own welfare, make investment decisions by comparing the costs of those investments to the present value of the income stream they produce. Investments are undertaken when the present value exceeds the associated cost and the return is greater than the returns from available alternatives. Applying that paradigm, labor economists have been able to explain much about observed patterns of labor supply, productivity, and earnings growth.

For the most part human capital theory has focused on the decisions made by individuals. The analysis has helped explain a variety of labor market phenomena, including income differences across individuals, the trajectory of earnings over an individual’s work life, and investments in education and on-the-job training and their respective returns as well as patterns of occupational and job mobility and the duration of employment. It was from this work that the critical distinction between general human capital and firm-specific human capital arose. Since the development of firm-specific human capital makes separation more costly for both the employee and the employer, the balance of general and firm-specific human capital achieved by employees has direct implications for the expected relationships between employee tenure and both pay and turnover. Human capital theory provides a road map for understanding those relationships and the ways labor markets value the different types of human capital.[3]

Human capital theory also made it necessary for economists to deal formally with issues that involve the heterogeneity of labor. Traditional microeconomics had abstracted from this issue altogether, characterizing labor as a homogeneous input to production that was measured by headcount or labor hours alone. Since human capital develops differently, depending on the investment choices made, the quality of labor will vary considerably. Thus, labor markets have the additional burden of helping to match individuals to jobs and organizations in a way that finds the highest value for those resources. Theories of “matching,” “job search,” and job market “signaling” were developed, in part, to help explain how these objectives are fulfilled through labor market institutions and the conditions under which outcomes are optimized. These are important complements to—and, in some respects, extensions of—human capital theory.[4]

It is quite straightforward to extend the human capital paradigm in an attempt to understand the investments in human capital made by organizations. For economists, human capital in organizations represents the stock of human assets—consisting of the accumulated knowledge, skills, experience, creativity, and other relevant workforce attributes—that drive the flow of labor services to the firm. It is important to understand the distinction economists make between “stocks” and “flows.” That distinction is equivalent to the difference between wealth and income. Wealth is a stock variable; it can be measured in financial terms at a given point in time. Income is a flow variable; it has no meaning without reference to time (it is measured as $X per year, month, etc.). Human capital is the equivalent of the accumulated human “wealth” of an organization: the productive potential of its workforce. Labor productivity is in effect the income generated from that wealth. Hence, an organization will invest current resources in training to improve the quality of its workforce and, it expects, generate higher productivity over time. Such enhancements in labor quality are viewed as increases in the organization’s stock of human capital. Increased productivity, if it materializes, reflects an increased flow of labor services from that stock of human capital and can be used as a measure of the return on the organization’s investment in human capital.

Optimizing the productive potential of an organization’s workforce by itself cannot ensure that the workforce will generate the expected return in terms of actual productivity. Obviously, productivity also depends on how the workforce is deployed and motivated. To be efficient, labor markets and other labor market institutions, such as internal labor markets, must provide for optimal utilization of human capital as well. This is where incentives come into play.

Incentive problems arise because of imperfections and asymmetries in the information available to the employer and the employee. If employers could observe perfectly both the quality of labor they employ and the actual labor input (e.g., effort and diligence) employees provide to the firm, there would be no selection or incentive problems with which to deal. Screening would ensure that those hired had exactly the capabilities required by the business. Contracts would focus on labor inputs alone—not outputs—and pay only for actual services delivered.

However, reality is far different from this idealized picture. Indicators of labor quality such as education, prior job history, and even testing are incomplete and often erroneous. And usually only proxies for actual labor effort and diligence (e.g., hours worked) can be observed. For example, it is possible that “lower-ability” recruits will pass for “higher-ability” ones. An efficient employment contract should minimize this contingency. If, for example, the compensation arrangement provides incentives for the lower-ability people to join the firm when the need is for high-ability employees, there is an “adverse selection” problem that undermines performance. Similarly, if the compensation system provides incentives for employees to shirk or to free ride on the efforts of others, this incentive or “moral hazard” problem will lead to diminished productivity in the existing workforce.[5] Thus, the structure of the employment relationship matters a great deal.

Economists have focused considerable attention on understanding the employment relationship and the nature of labor contracting. Much of that research characterizes the optimal employment contract under different assumptions about the information available to the employer and the employee and differences in their attitudes toward risk.[6] Risk comes into play because of uncertainty about both the outcomes of productive activity and those of the employment relationship. Someone will bear the burden of those risks, but who? To what extent will it be shared between the employer and the employee? These are questions with which every employment contract must deal.

Using a classic optimization approach as well as applications of game theory, economists have examined conditions under which different types of employment contracts arise. Their research addresses multiple dimensions of the employment relationship, including pay, career progression, and employment security, among others. It addresses questions such as the following: What determines the relative efficiency of fixed wages and salaries compared with individual incentives such as piece rates? When are group incentives optimal, and what solutions exist for the free rider behaviors that often are associated with those rewards? Under what circumstances are relative performance measures more effective than absolute measures in incentive programs? When are competitive compensation schemes in which employees vie for promotion up the career hierarchy appropriate for optimizing workforce productivity? What determines the size of differences in pay across levels in the hierarchy? A series of theoretical models have been developed that shed light on the optimal design of employment contracts and rewards under different conditions. Those models are useful in assessing the likely effectiveness of contracts observed in practice.

That research has been extended to examine the implications of incentive problems for organization structure, addressing issues such as why and how hierarchies arise, the links between the intensity of supervision and compensation costs, and even the role and value of bureaucracy in organizations. It speaks to the systemic nature of human capital management, in which structure and practice interact to influence behavior.

The body of research cited above is invaluable for understanding internal labor markets and the productivity of human capital in organizations. It has guided us in developing our analytic tools, clarifying key relationships among variables, and providing a basis for interpreting empirical patterns uncovered through statistical analyses.

The theoretical and empirical models that have been developed tend to be more narrowly focused and less systems-oriented than are those in the psychological literature, but they are rigorously formulated and offer clear, testable predictions. When combined, they provide rich insights into and data on the ways internal labor markets function and the ways human capital affects performance. The theoretical work indicates what one should look for in evaluating data. The models specify efficiency conditions for various aspects of human capital management under different contingencies. They are context-sensitive. The empirical work provides a vast array of normative data concerning key relationships. Those relationships are best used not as benchmarks to be mimicked by an organization but as a way to understand the uniqueness of the organization and the reasons such differences may be appropriate.

No discussion of the research base of our work would be complete without reference to the growing body of empirical research on the links between human capital management and labor productivity. Much of the most significant empirical research consists of econometric studies of the relationship between specific types of interventions and productivity and/or a firm’s financial performance.[7] Most of this research involves the statistical analysis of samples of firms in particular industries or across industries. The most common approach has been to estimate a production function that is “augmented” to include variables that represent the human resources interventions of choice. Control variables representing industry- or firm-specific characteristics and/or demographic attributes of employees often are used to take account of the contextual factors that may influence program performance. The performance variables that are used most commonly are value added, value added per employee, net sales per employee, and profitability.

Here too economic research has been focused more narrowly than has the work in organizational psychology. Empirical research in economics has been concerned primarily with financial incentives, employee participation, and a number of practices aimed at the selection and development of human capital, such as training and screening. A few studies have examined other aspects of human resources (HR) systems, such as job design, seniority-based promotion, supervision intensity, information-sharing arrangements, and managerial attitudes toward employees (i.e., “values”).[8] However, such studies are quite exceptional. Nonetheless, they are a hopeful sign of the expansion of empirical research to complement the extensive theoretical work in personnel economics.

[1]Edward P. Lazear, Personnel Economics (Cambridge, MA: MIT Press, 1995).

[2]For actual references see Chapter 11, endnote 2.

[3]A review of the literature can be found in Robert J. Willis, “Wage Determinants: A Survey and Reinterpretation of Human Capital Earnings Functions,” in O. Ashenfelter and R. Layard (eds.), Handbook of Labor Economics, Vol. 1, Amsterdam: North Holland, (1986), 603–638.

[4]See, for example, B. Jovanovic, “Job Matching and the Theory of Turnover,” Journal of Political Economy, 1979, vol. LXXXVII, 972–990, and Dale T. Mortensen, “Job Search and Labor Market Analysis,” in O. Ashenfelter and R. Layard (eds.), Handbook of Labor Economics, Vol. 2. (1986). Amsterdam: North Holland, 849-919 The seminal work on signaling is A.M. Spence, “Job Market Signaling,” Quarterly Journal of Economics, 1973, vol. 87, 355–374.

[5]For references concerning the issues of adverse selection and moral hazard and their relevance to employment contracts, see Chapter 10, endnote 5.

[6]A more detailed survey of this research literature can be found in Donald O. Parsons. “The Employment Relationship: Job Attachment, Work Effort and the Nature of Contracts,” in O. Ashenfelter and R. Layard (eds.), Handbook of Labor Economics, Vol. 2 (1986): Amsterdam: North Holland, 789–848.

[7]Examples of this work include: A. Bartel, “Productivity Gains from the Implementation of Employee Training Programs,” Industrial Relations, 1994, vol. 33, 411–425, J. Cable and N. Wilson, “Profit Sharing and Productivity: An Analysis of U.K. Engineering Firms,” Economic Journal, 1989, vol. 99, 366–375, and F. R.Fitzroy and K. Kraft, “Cooperation, Productivity and Profit Sharing,” Ouarterly Journal of Economics,1987, vol. 102, 22–35.

[8]See, for instance, Casey Ichniowski, K. Shaw, and G. Prennushi, “The Effect of Human Resource Management Practices on Productivity,” American Economic Review, 1997, vol. 87, 291–313, D. J. B. Mitchell, D. Lewin, and E. Lawler, “Alternative Pay Systems, Firm Performance and Productivity,” in A. Blinder (ed.), Paying for Productivity (Washington, DC: Brookings Institution, 1990), 15–88, and Paul Osterman, ”How Common Is Workplace Transformation and Who Adopts it?” Industrial and Labor Relations Review, 1994, vol. 47, no. 2, 173–188.




Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[.  .. ]ntage
Play to Your Strengths(c) Managing Your Internal Labor Markets for Lasting Compe[. .. ]ntage
ISBN: N/A
EAN: N/A
Year: 2003
Pages: 134

flylib.com © 2008-2017.
If you may any questions please contact us: flylib@qtcs.net