Organizations and Markets

Review Papers on Personnel Economics

2 January 2008 at 12:23 pm Peter G. Klein 1 comment

| Peter Klein |

The economics of human resource management, or personnel economics as it’s come to be called, is surveyed in two new papers, this one by Edward Lazear and Paul Oyer for the forthcoming Handbook of Organizational Economics and this one by Lazear and my former CEA boss Kathryn Shaw for a future issue of the Journal of Economic Perspectives.

These reviews emphasize the generality of the economic approach and argue that it explains observed HR practices, such as the rising variance in pay across individuals, increased use of pay-for-performance schemes, greater reliance on teamwork, and the like better than rival theories. E.g., from Lazear and Shaw:

In the not-too-distant past, the typical textbook on human resources management would often 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 and institutionally driven, economists place a premium on identifying the underlying general principles, and on using specific institutional details to identify the causal sources of the general principles.

I’m not sure all our sociologically and psychologically inclined readers will be comfortable with this generalization. Anyway, Lazear and Shaw’s conclusion, which describes the growth of the field, is worth quoting in full:

For most of the last century, personnel, later called human resources management, was the territory of industrial psychologists and those who studied organizational behavior. But in the 1970s, economists began to bring the formalism and rigor of economic thinking to human resources. The model for personnel economics, the field that grew out of that endeavor, was modern finance. Finance was historically an institutional field without much theoretical or even empirical underpinning until the modern developments of scholars like Merton Miller, Harry Markowitz, William Sharpe, Eugene Fama, Fischer Black, Myron Scholes, Robert Merton, and many others who followed in their footsteps. These scholars transformed the field of finance into a branch of economics in large part by recognizing that a few basic principles, such as arbitrage, governed financial markets. Personnel economics has followed a similar path and is beginning to gain the prominence that modern finance has enjoyed.

What does personnel economics add to traditional methods of studying human resources management? Most labor economists who taught in business schools have traditionally encountered a disinterested audience. Traditional topics of labor supply and demand, unemployment, and investment in education, which are of primary concern to labor economists, are almost irrelevant to their business students. The issues studied by human resources specialists were of interest to economists, but the approach taken by the noneconomists lacked the formal framework to which economists have grown accustomed. The entry of economists into the field of human resources management was assisted by breakthroughs in agency and contract theory, which enabled economists to tackle problems that had evaded them in the past. Entry was further assisted by advancements in econometrics, including ways of addressing sample selection bias, omitted variable bias, and endogeneity, as well as by the use of panel data, which allowed economists to formulate and test models in a way that closely approximated experiments in the use of alternative human resource management practices.

In providing guidance to firms in the choice of their human resource management practices, several themes have emerged. Many of the models emphasize the importance of “fit.” Firms and workers achieve fit when a worker’s skill set, broadly understood, is matched to the firm that values it the most. Workers, or potential employees, have very heterogeneous skills and preferences. Because measuring the output of individual workers is often difficult, it becomes especially important to think about the incentives workers face. Pay for performance  may not just induce the higher effort levels, but may also induce workers to select the firm that is the best fit for their skills, effort, and tastes. Personnel economics emphasizes the importance of human resources practices for inducing workers’ self-sorting to firms.

Better fit or performance is achieved when complementary people are matched to each other within the firm, or when complementary human resources practices are matched to each other. People are complements when the skills of one enhance those of another within their team. Human resources practices are complements when one practice — such as teamwork — is combined with another practice — such as group-based incentive pay — such that together they raise output more than would either practice independently.

Alfred Marshall’s ([1890] 1961) famous statement that it is not the economist’s business to tell the brewer how to brew beer has not been adhered to when it comes to personnel economics. Personnel economists, at least in their interactions with business students and practitioners, are attempting to use the tools of economics to understand, and even sometimes to guide, practices.

Entry filed under: - Klein -, Management Theory.