Large Firms and Internal Labor Markets

This paper introduces a model of internal labor markets that is consistent with the observed differences between workers in large and small firms with respect to wages and separation rates. In particular, firms constitute labor markets with no search frictions. Workers are free to move within a firm at no cost, whereas switching across firms is costly. If the quality of a match between a worker and a occupation/department/team within a firm is uncertain, then larger firms offer more opportunities for workers to find the right match. As a result, workers abandon unpromising matches more easily and are more likely to be employed in better matches. In equilibrium, workers in larger firms are more productive, earn higher wages and are less likely to quit, even conditional on their wage. Using data from the 1996 SIPP we find support for the predictions of our framework: internal mobility is higher in larger firms and depends negatively on wages and tenure; workers in larger firms switch occupations at higher wage levels and receive higher wages in their new occupation; the size-wage premium is higher for workers with longer tenure, while workers who leave large firms continue to enjoy high wages, but only if they remain in the same occupation; and finally the wage and size effects on the separation probability are significantly larger for workers who switch occupations.