Personnel Economics: The Economist's View of Human Resources
GAICIL Insights
For most of the last century, human resources was a field of intuition: industrial psychology, organizational behavior, rules of thumb.1 Personnel Economics: The Economist's View of Human Resources, by Edward P. Lazear and Kathryn L. Shaw, tells how economists turned it into a field of principles. Beginning in the 1970s, personnel economics brought the formalism and rigor of economics to compensation, hiring, training and teamwork, drilling deep into the firm with new tools and new answers.
The authors offer an illuminating analogy. The model for personnel economics was modern finance. Finance was historically an institutional field without much theoretical or empirical underpinning until scholars recognized that a few basic principles, such as arbitrage, governed financial markets. Personnel economics followed a similar path, applying a small set of economic principles to human resource design, and is beginning to gain finance's prominence.
The questions are concrete. Why should pay vary across workers within firms, and how compressed should it be? Should firms pay for performance, skills or hours? How should pay and promotions be structured to induce optimal effort? Why use teams, and how? How should these practices be combined? Personnel economics analyzes all of them inside one framework.
Artificial intelligence is about to stress-test every answer at once. AI changes what firms know about performance, which tasks workers do and how teams are organized. Each shift moves the optimal design of HR practices. When performance becomes easy to measure, pay for performance grows more attractive. When tasks are automated, the skills firms reward shift. When AI coordinates work, the value of teams and the shape of hierarchy change. Personnel economics is the toolkit for working through those effects systematically, and AI makes the toolkit urgent.
The field's emphasis on complementarities is the critical warning. Practices work together. Incentive pay, teamwork and training are complements: adopting one without the others may fail. AI adoption faces the same trap. Introducing AI tools without adjusting compensation, training and organization may disappoint. The productivity payoff from AI depends on complementary HR changes. Firms that buy the software and leave the pay plan untouched may be buying half a solution.
The authors note that traditional labor economics topics, labor supply and demand, unemployment, seemed almost irrelevant to business students, while noneconomic HR approaches lacked a formal framework. Personnel economics built the bridge. In the AI era the bridge carries heavier traffic. Managers need frameworks linking technology adoption to job and incentive design, and economists need to study those decisions inside firms.
Policy should take note. Personnel economics cautions against treating firms as black boxes. Rules on pay transparency or restrictions on certain incentive structures interact with internal firm design. As AI changes that design, policies constraining firms' ability to adapt HR practices could limit gains from the technology. Understanding how firms organize work is a prerequisite for sound labor policy, a point easily lost when rules are written for an abstract average employer.
The field's rigor also offers a method for judging AI in HR itself. AI is increasingly used in hiring, evaluation and promotion. Economic analysis can test whether such tools improve matching and incentives or introduce new distortions, and firm-data studies, the field's hallmark, can measure their effects precisely. An algorithm that screens applicants is a personnel policy, and it deserves the same scrutiny as any pay plan.
The broader message is that managing people is a domain where economic principles yield powerful insights. Personnel economics transformed HR into a rigorous discipline. As AI transforms the workplace, the same principles will help firms redesign compensation, hiring, training and teamwork for a new technological environment, and help policymakers see how those choices shape productivity and worker well-being.
The most important AI adoption decision inside many firms may be made in the compensation committee, long after the technology purchase is signed.
Introduction
Personnel economics drills deeply into the firm to study human resource management practices like compensation, hiring practices, training, and teamwork. Why should pay vary across workers within firms—and how “compressed” should pay be within firms? Should firms pay workers for their performance on the job or for their skills or hours of work? How are pay and promotions structured across jobs to induce optimal effort from employees? Why do firms use teams and how are teams used most effectively? How should all these human resource management practices, from incentive pay to teamwork, be combined within firms? Personnel economists offer new tools to analyze these questions—and new answers as well.
Takeaway
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?1
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.
Notes
- Edward P. Lazear & Kathryn L. Shaw, Personnel Economics: The Economist's View of Human Resources, 21 J. Econ. Persp. 91 (2007), https://doi.org/10.1257/jep.21.4.91. Takeaway source: Conclusion, reproduced from a free author or repository copy (working-paper version). ↩
Cite as: Edward P. Lazear & Kathryn L. Shaw, Personnel Economics: The Economist's View of Human Resources, 21 J. Econ. Persp. 91 (2007), https://doi.org/10.1257/jep.21.4.91
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