Horizontal Differentiation of Tasks and Skills: Internal and External Labor Markets, Part 1

When workers’ skills can only be revealed by matches into tasks, and then only via the productivity of their teams, productivity-improving internal re-matching should improve on skill information to the external market. We show that this is not necessarily so. Information generated in more productive firms may become garbled, even overturning productivity advantages generated in the internal market. We derive this and other results within a parsimonious parametric model in which we transfer and adapt the horizontal differentiation model known from the IO literature to a labor market characterized by symmetric imperfect information about the typical worker’s skills. Information about these skills is revealed only indirectly via the productivity of the teams in which the workers are active. Firms as teams vary in size, and technology reflected in their structure of tasks from specialized to diversified. Frictionless re-matching within the internal labor market improves on the team’s productivity. Misalignment between the distribution of skills and that of tasks can be removed only by external labor market actions, constrained by informational frictions. In part 1 of this paper, we analyze internal market equilibrium. For external market activities, we assume that firms can realize their imperfectly informed desired demand from a supply in which skills are revealed perfectly. In part 2, we realistically consider labor supply in the external market as in part furnished by separations, and structured by signals involving the typical worker’s employment history. We demonstrate generic opposite effects of internal on external market activities. In the internal market, constrained efficient re-matching yields the average productivity of firms to increase in size and diversity of structure. External market activity improves on firms’ expected productivity, but the strength of improvement decreases in firm size and diversity of structure: The more internal re-matching leads to leftward skewness in the distribution of firms towards higher productivity, the less informative is the specification of desired demand (and, as we show in part 2: in the supply) in the external market, which may overturn internal market effects.