External Labor Market Essay

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Labor  markets  provide  a  mechanism   for  employers and employees to agree on terms for exchanging labor input  for wages. In accepting  an employment relationship,  a worker agrees to receive wages (and other inducements) in exchange for submitting to the directives of the employing organization within some zone of indifference. On the labor supply side, individuals adjust their hours of work in the labor force on the basis of changes in income, career opportunities, and other conditions of employment. On the demand side, employers adjust their engagement  of labor on the  basis of changes  in relative prices  of labor, the quality of labor, and other constraints. For labor markets to operate efficiently and effectively, mechanisms must be in place to support  flexibility and adaptability to changing  levels of supply and demand,  while conforming  to social expectations  regarding  equity, morality, and so forth.

Labor markets  exist within the firm and external to the firm. Internal  labor markets are characterized by job ladders in the firm, supported  by evaluation systems  that  reward  skill development  and  worker commitment. Entry to the firm occurs mostly at the bottom  of the ladder, and movement  up the ladder follows the development  of skills. Internalized  work often comes with the implicit understanding that employment  is permanent, or at least long term. External  labor  markets,  by  contrast,   are  normally more  flexible, unless  they  are  tightly  regulated  by governments  or constrained  by the behavior of labor interest  organizations.  External market  transactions consist of contractual  relationships  that specify what each party to the exchange is to deliver. The simplest form of employment  contract  is the spot contract  in which all obligations are fulfilled on the spot, as in the case of hiring day labor without  any obligations for the future. To the extent that internal  labor markets produce employment  stability, internalization makes it expensive and politically difficult to adjust the volume of labor to changing internal organizational and external  market  conditions.  This is the main reason why firms typically externalize labor—draw on external labor markets—when they recruit workers.

Under normal conditions, internalization increases the  employer’s organizational  control  over employees, whereas externalization  enhances organizational flexibility. Externalization  of labor  is typically seen as  a  means  to  complement   internalization and  to circumvent  some of the problems  created  by internal labor  markets.  In some  Western  countries,  the external labor market is extremely dynamic, as in the United States where the proportion of new job-person matches over a five-year period has been estimated to be about 40 percent, with significant variations across age groups.  General  inter-country comparisons  are not very revealing if they ignore differences in labor movement in terms of opportunity factors such as the size distribution  of firms in a given industry and the degree of job growth over the business cycle

Recent  Developments

Recent decades  have seen significant developments in labor markets  in the international arena, as firms are  trying  to  regain  some  of  the  competitiveness they have lost because of rising labor costs and the growing success of producers  in newly industrializing nations. One strategy many firms use to contain labor costs is to introduce  a variety of flexible working arrangements that  are expected  to improve  the link between the level of output  and the demand for labor. Some of these arrangements are based on using the external labor market as a source of employment flexibility. The most prominent of these arrangements include increased reliance on subcontracting and the increased  use of temporary  employment  contracts. Both are considered  forms of employment  externalization.  Externalization  through  the  use of temporary workers has the effect of reducing the duration of employed labor in the firm, whereas externalization through subcontracting activities to independent workers is a means of increasing flexibility by reducing administrative  control over labor.

Subcontracting involves the replacement of employment contracts  in the firm with commercial contracts with external firms supplying specialized inputs. This approach  is widely used in industries  facing volatile market conditions, such as construction, where workers move from one contract  to the next or are laid off until the firm obtains another order. They are also frequently used in industries that rely heavily on project work, as in the cultural  sector (e.g., performing  arts, film production,   writing,  and  publishing).  In  these industries,  many firms can meet fluctuating  demand best by outsourcing  activities to specialized organizations and individuals that can supply them at the time when they are needed, while retaining in-house those activities that focus on their core business.

Temporary employment refers to the use of workers hired for a fixed term. These include workers provided by temporary  help service agencies, limited-duration hires, and call-ins. In many countries, temporary workers (often referred to also as contingent  workers) have comprised  one of the fastest growing labor force segments. It would be wrong to view contingent  workers primarily as low skilled. Contingent  workers include professionals such as engineers, teachers, nurses, and orchestra directors. Many of these temporary workers are highly paid, and there is some evidence that many of them view their temporary employment as voluntary rather  than imposed by the state of the labor market. Temporary status may also lead to permanent employment, if the firm uses the arrangement as a recruitment device to observe the worker’s qualifications and commitment until a decision is made whether to offer long-term employment.

Research typically explains the use of subcontracted  and temporary  labor in terms  of the advantages contingent  employment  arrangements produce for the  employer  in terms  of flexible staffing, cost savings, obtaining  expertise,  and  a variety of other benefits.  One  may  distinguish  between  numerical and  functional   staffing  flexibility. Numerical   flexibility refers to the ability to adjust staffing levels to changes in market conditions  more easily than what is possible with permanent staff who are protected by government  regulations  regarding hiring and firing and who expect employment  stability. Functional flexibility contributes required  skills to the firm that are costly to develop in-house,  especially if they are used only sporadically or are difficult to monitor  by the employer because control over the use of skills lies with the worker. Drawing workers from the external labor market  also provides  the  firm with cost flexibility to the extent  that  it can economize  on fringe benefits and social insurance payments. And the use of independent contractors allows the firm to provide a broad range of specialized products  without incurring the risks from large investments  in recruitment, skill training, and labor monitoring.

When  are firms most  likely to externalize  labor? The use of temporary  workers is certainly not a new phenomenon. Employers  have long organized  production  around  fixed-term (and part-time)  positions in order to cope with fluctuating market demand, as in retail and the hospitality industry. What appears to be new is the extent to which firms rely on contingent workers to hold down labor costs. It would also be too simple to argue that firms draw (more) extensively on external labor markets only because high(er) levels of uncertainty  in product  markets  require  a strong(er) concern for containing labor costs. A focus on market uncertainty  and labor costs is in many cases too narrow. While  the  employment  of contingent  workers may help to contain  labor costs, organizational  factors and job factors may reduce these cost savings.

An important variable to consider is the nature and extent  of workflow interdependence. In those  cases where activities and jobs are highly interdependent, extensive use of temporary or contract workers carries the risk of disruption and insufficient control over the flow of labor resources. Research suggests that firms are more likely to externalize labor if parts of the production  process can be distributed  and technologies are available that  enable outsourcing  and  adjusting the volume of output.  There are also organizational factors to be considered.  If, for example, employers cannot introduce bureaucratic controls—for example, because of union rules or government regulation—to ensure a sufficient level of commitment on the part of short-duration hires, they are less likely to externalize employment.  Within  any organization,  there  are a range of “hidden costs” associated with monitoring, motivating, resolving conflicts, and coordinating permanent  and nonpermanent workers that limit firms’ use of external labor markets.

The  evidence  shows  that  there  is a  clear  trend toward  increased  labor  market  flexibility in  many industrial  countries.  However, this  trend  builds  on markedly different bases. Extensive reliance on external labor markets has existed in the United States for a long time. Employers in Europe seem to be catching up fast, although  in varying degrees in different European  countries.  Also, the  form  and  nature  of labor externalization  is different across countries.  In Europe, one can observe a north/south divide, with part-time  and temporary  employment  arrangements being more popular with employers in many southern European countries.

Variability  in  labor  externalization   is not  determined  by  employment   legislation  alone.  Firms  in both   high-regulated   and   low-regulated   countries draw on external  labor markets,  and in many cases the increase in labor externalization in recent decades is similar. There is some debate concerning  whether there is convergence or divergence across countries in firms’ reliance on external labor markets. Those who argue  that  divergence  is taking  place  suggest  that, despite  globalization,  firms continue  to  be embedded in regionally or nationally  distinct  societal and institutional arrangements. Others who observe international convergence argue that firms’ practices are  increasingly  disembodied  of the  national  context, overriding more regionally or nationally specific institutions  or cultural predispositions.

Some also suggest that  convergence  is a function of business activities becoming internationalized through  exposure  to  customers,  suppliers,  or  alliances  with  foreign  firms. Even enterprises  that  do not participate in international markets are subject to competitive  pressures  and regulations.  By imitating and learning from each other,  firms adopt  common organizational  practices,  including  recruiting  workers from the external labor market.


  1. Brewster, L. Mayne, and O. Tregaskis, “Flexible Working in Europe,” Journal of World  Business (v.32/2, 1997);
  2. Florence Jaumotte  and  Irina  Tytell, How Has the Globalization  of Labor Affected the Labor Share in  Advanced  Countries? (International  Monetary  Fund, 2007);
  3. John Masters and Grant Miles, “Predicting the Use of External Labor Arrangements: A Test of the Transaction Costs Perspective,” Academy of Management  Journal (v.45/2, April 2002);
  4. Jan Rutkowski, Labor Market Developments During Economic Transition (World  Bank, Europe and  Central  Asia  Region,  Human  Development  Sector Unit, 2006);
  5. Vicky Smith, “New Forms of Work Organization,” Annual Review of Sociology (v.23, 1997).

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