Organizations have always been faced with the dilemma of using external or internal labor markets. Hiring and promotion practices vary depending on whether firms use internal or external labor markets. External-labor-market firms concentrate on recruiting from the outside, while internal-labor-market firms concentrate on promotions from within. Organizations that depend on an internal labor market make hiring decisions with a long-term outlook and hire individuals with the idea that these individuals will stay with the company for a long time. These organizations are very concerned with promoting from within, obtaining commitments from their employees, and rewarding seniority.
Early organizational theorists believed that internal labor markets would be advantageous to organizations because they would allow employers to develop a motivated and specialized workforce. Management efficiency arguments also support the use of internal labor markets. Managers can create greater efficiency by reducing their dependence on the external labor market. This independence reduces their need for information about future external labor markets. Managers and workers may both benefit from internal labor markets. Management will have reduced transaction costs and greater loyalty, whereas workers will have greater security and stability.
Internal labor market models demonstrate distinct job ladders that employees follow. There may be multiple internal labor markets within one firm. Job ladders allow entry only at the bottom, and movement up the ladder is believed to be associated with an increase in skill. A person’s future career path is primarily determined by the job ladder on which he or she enters the firm. An employee’s entering job determines future advancement probabilities. The internal labor market job ladder model hypothesizes that once an individual is on a career ladder, his or her career options are limited by the ladder.
Within internal labor markets, potential employees encounter barriers to entry into the firm’s workforce and are restricted to a number of low-level positions from which they must work their way up. People within the organization enjoy job security and anticipate future advancement, reducing the probability of turnover and increasing their commitment to the organization. In an internal-labor-market organization, an employee’s job assignment, tenure, and hierarchical level are the direct outcomes of managerial decisions, in contrast to an external-labor-market organization, where outside labor forces affect who fills the top positions in the firm. Managerial decisions in internal-labor-market firms constitute the enacted promotion policies of an organization. Firms using external labor markets are not as dependent on their recruiting and promotion practices as are internal-labor-market firms.
Internal labor markets are believed to reduce turnover and keep the transaction costs associated with turnover to a minimum, while at the same time helping the firm obtain greater employee loyalty. Firms that invest in their employees to develop company-specific knowledge tend to have internal labor markets and work to develop and retain their workforces.
Organizations may use different labor markets depending on the degree of professionalization or specialization a firm requires. If a worker’s skills are highly portable, that employee is easily replaced, leading to use of an external labor market. If a firm requires a high degree of specialization, employees with these skills are not easily replaced. Therefore, the organization must attempt to retain the employee and may use an internal labor market.
The subject of external versus internal labor markets is often looked at cross-culturally. The United States is portrayed as having a short-term perspective and using external labor markets, while Japan is portrayed as having a long-term perspective and using internal labor markets. Japanese firms’ high productivity is often attributed to their strong culture. Nonetheless, many firms in the United States do maintain a long-term perspective in their hiring and promotion decisions and utilize internal labor markets.
To select and retain the best employees, managers must be aware of the determinants of career attainment in their firms. Such an understanding is especially important in internal labor markets, because outsiders are not allowed access to high-level positions in the firm. Therefore, market forces do not ensure that the best employees attain top slots. These top slots will be filled by those already employed by the firm. Therefore, it is imperative in internal labor markets that the determinants of career attainment in the firm are consistent with their intended promotion policies; a misalignment between policy and practice may lead to firms’ not promoting and retaining the most-talented individuals.
It is also important to consider that firms limited to an internal labor market may not be getting the best talent available. Internal labor markets rely on their existing employees and do not look to the external market to replace their employees with the most-talented individuals available in the market.
Employees in internal labor markets also need to be aware of the career attainment determinants in their organizations. Recent literature has highlighted the effects of unethical behavior in internal labor markets. Employees or managers who are perceived as performing unethical practices, such as earnings management, are often passed over for promotions in internal labor markets. This appears to occur whether or not the company approves of the unethical behavior.
Attempts by firms to partially utilize internal labor markets are usually unsuccessful. Research has shown that when an internal-labor-market firm does hire employees from the external market, these external hires have a quicker promotion rate than existing employees. Current employees may notice the hires from the external labor market being promoted faster than they are and make plans to exit the firm.
While the benefits and costs of internal and external labor markets will continue to be examined for years to come, it is essential that both employees and employers be aware of these benefits and costs. Organizations and individuals must make informed decisions based on their own needs and their perceptions of how these needs can be met.
- Althauser, R. P. and Kalleberg, A. L. 1990. “Identifying Career Lines and Internal Labor Markets within Firms: A Study in the Interrelationships of Theory and Methods.” Pp. 308-356 in Social Mobility and Social Structure, edited by R. L. Breiger. New York: Cambridge University Press.
- Cappelli, P. and Cascio, W. F. 1991. “Why Some Jobs Command Wage Premiums: A Test of Career Tournament and Internal Labor Market Hypotheses.” Academy of Management Journal 34:848-868.
- Hurley, A. E. and Sonnenfeld, J. A. 1998. “The Effect of Organizational Experience on Managerial Career Attainment in an Internal Labor Market.” Journal of Vocational Behavior 52:172-190.
- Stewman, S. 1986. “Demographic Models of Internal Labor Markets.” Administrative Science Quarterly 31:212-247.