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Personnel Economics.

Personnel Economics Edward P. Lazear The MIT Press, Cambridge, MA, and London, 1995, 170 pp., 19.95 [pounds sterling]

In this short book Edward Lazear provides a masterly outline of the economic analysis of personnel. For many years labour economics, with its emphasis on human capital theory, has been the standard fare for those studying personnel or human resource management at either undergraduate or postgraduate levels, or for professional qualifications. To many personnel specialists, however, the economists' approach often seems to be too abstract to be of any practical use. The optimizing models, which contain relatively few variables and which are acclaimed on the grounds either of their mathematical elegance or of their empirical performance, often fail to explain the way in which organizations are structured and how people behave within those structures. Few clues are provided as to how to improve efficiency except at the level of government policy, for example towards education, training, the appropriate amount of regulation and so on. The analysis of internal labour markets (ILMs), pioneered by Doeringer and Piore, is perhaps one of the few exceptions.

The work on ILMs can be seen as a turning point, or possibly the starting point, for the development of a more specialized economics of personnel. Human capital theory and the traditional labour economics approach focuses on how the labour market works, and thus on those factors that are external to the firm. By contrast, the ILM approach shifts the spotlight to the internal workings of the organization and has led economists to ask questions that have been the preserve of personnel specialists with a background in sociology, psychology and industrial relations. These include such matters as optimal employment contracts (tournament theory), pay structures and incentives, organizational hierarchy and the best composition of work teams. It is to such areas -- known as the economics of personnel -- that Lazear's book is devoted.

Lazear's claim is no less than what most economists claim for their discipline, namely that by the use of simplifying assumptions and rigorous analysis, economics can focus on the crucial questions in personnel, providing both solutions to problems and generalizations about human relations in the workplace. Thus on page 2 he writes: "The task of the personnel economist is to find simple models that do well in describing important components of worker behaviour." Moreover, it is not just the components, but also the structure, of the personnel system that is amenable to economic analysis. This Lazear demonstrates in nine chapters -- in addition to the introduction and conclusion -- that cover key personnel topics including, among other things, various aspects of pay systems, the nature of jobs, job evaluation, labour market institutions and hierarchical structures in organizations.

As one would expect, Lazear examines each of the specific issues by first developing a simple model, usually an optimizing one, from which the main implications for personnel practice are drawn out. They are then assessed against the empirical work, where there is any, as well as against more casual observations of organizational behaviour to test for their real-world applicability. One interesting feature of this work is that it is positive and normative at one and the same time, explaining what is, as well as offering suggestions for increasing or maximizing organizational efficiency (and profitability) and worker utility. A few examples will suffice to illustrate the approach.

In the chapter on fixed and variable pay schemes (i.e. time- versus piece-rates), it is shown that optimal piece rates are linear, with workers receiving the full residual profit (after all costs) but paying a rental price for the job. This normative conclusion also accords with some observations of salesmen, who receive commission but must meet a minimum sales target, and taxi drivers, who pay a rental for the cab but keep the takings. The analysis is subsequently extended to show how the choice of piece- or time-rates depends in part on the costs, the ability of employers to measure output accurately, and the degree of risk aversion among workers. Chapter 4 considers the now well-established empirical fact of an upward sloping age-earnings profile and the question of mandatory retirement. Lazear suggests, quite reasonably, that the phenomenon of pay increasing with age is a motivational device, providing workers with a reward for past productivity, an incentive for maintaining effort in the future and a spur to young workers. Furthermore, to prevent the rising lifetime earnings from forcing firms to introduce mandatory retirement, it is also demonstrated that it is possible to derive an optimal pension plan which induces the worker to retire at the appropriate time, i.e. when the expected present value of the pension is maximized. A third example is team compensation, the benefits of which Lazear disputes because of the incentive to free ride in all but the smallest of teams (i.e. when monitoring costs are low). It is shown that the a necessary condition for efficient profit sharing schemes is that some (implicit) penalty is imposed on a shirking worker either externally from peers (shame) or internally (guilt).

These three examples, which are but a small sample in the book, show not only that personnel economics has something distinctive to offer the study of organizations, but also that it is relevant and useful. Furthermore, the book is not just a series of separate topics; there is a central theme running through much of Lazear's analysis. This is the importance of relative levels as contrasted with absolute levels (e.g. in pay), which is developed using tournament theory, a model first outlined in his paper with Rosen (Lazear and Rosen, 1981). As the name suggests, tournament theory suggests that designing a job structure in an organization with effective incentives to elicit employee efficiency can be likened to a tournament in sport such as tennis or golf where the prize is promotion and the salary increase that comes with it. There are three elements: first, the prize -- the salary increase -- is fixed in advance; second, the winner wins promotion by virtue of his or her relative performance,

i.e., not by being good per se but by being better than any rivals; and third, the effort induced by the tournament depends on the size of the prize -- the increase in salary.

That tournament theory is a useful tool, both for understanding how organizations work and in helping to devise personnel policies, is shown by the wide-ranging applications in the book. They include relative pay, the role of bonus and stock option schemes, the methods firms use, or might use, to minimize the adverse effects of rivalry and competition between employees, and the reason why firms define jobs in the way that they do. This last application is especially important since it has always been a major shortcoming of the human capital approach, with its emphasis on an individual's skills and productivity, that it is unable to explain the existence of job slots. The tournament model offers a coherent economic theory of why organizations devise jobs and hire and promote people into them and not just hire individuals for their productive attributes.

There are, naturally, some drawbacks to the approach to personnel issues of this book. One is illustrated in the chapter on evaluation where Lazear cuts a swathe through the arbitrariness, illogicality and ambiguity of HRM practices and textbooks, but then replaces it with an alternative that is just as arbitrary. This reviewer would also like to question how much can be explained by the competition and controlled rivalry of tournament theory. Lazear is fond of sports analogies, but life is not really like a game of tennis. Finally, there is at times a tendency to skate over important social or cultural variables, which, if not dismissed, are demoted to the status of extraneous factors. It is, of course, the method of economics to emphasize a limited number of crucial variables, and while this leads to an analysis that is crisp and clean, with conclusions clear and logically derived, something may be lost in the process. A qualitative approach may be messier and the conclusions less clear and generally applicable, but it can have the advantage of being a richer analysis. An example is the model used to explain the distribution of men and women between jobs, in particular why the average ability of women in every job is higher than the average ability of men, despite the dominance of men in good jobs. The model, which sorts workers between jobs optimally, shows that this is not due to differences in average abilities, but is because women have a higher alternative use of their time. Without doubting that there are elements of truth in this explanation, it is only a partial one; social and cultural factors are so important in explaining male-female differences in the workforce, e.g. as in the determinants of the value of alternative uses of time.

This book is not just first-class economics by a top economist, it is a pioneering work in a new(ish) area. It should be read by anyone interested in a rigorous approach to personnel matters -- student, researcher, teacher and practitioner alike -- as a first introduction to the more technically demanding journal articles where Lazear first expounded his ideas. It is elegantly written, and those who struggle with the mathematics will find the explanations, which are illustrated with numerous examples, easy to follow.


Lazear, E.P. and Rosen, S. (1981), "Rank-order tournaments as optimum labor contracts", Journal of Political Economy, Vol. 89 No. 4, pp. 841-64.
Stephen James
School of Social Sciences
University of Teesside
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Title Annotation:Review
Author:James, Stephen
Publication:Personnel Review
Article Type:Book Review
Date:Apr 1, 1997
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