Employee Referrals and Efficiency Wages

Abstract

Many workers believe that personal contacts are crucial for obtaining jobs in high-wage sectors. On the other hand, firms in high-wage sectors report using employee referrals because they help provide screening and monitoring of new employees. This paper develops a matching model that can explain the link between inter-industry wage differentials and use of employee referrals. Referrals lower monitoring costs because high-effort referees can exert peer pressure on co-workers, allowing firms to pay lower efficiency wages. On the other hand, informal search provides fewer job and applicant contacts than formal methods (e.g., newspaper ads). In equilibrium, the matching process generates segmentation in the labor market because of heterogeneity in the size of referral networks. Referrals match ‘good’ high-paying jobs to well-connected workers, while formal methods match less attractive jobs to less-connected workers. Industry-level data show a positive correlation between industry wage premia and use of employee referrals. Moreover, evidence using the NLSY shows similar positive and significant OLS and fixed-effects estimates of the ‘returns’ to employee referrals, but insignificant effects once sector of employment is controlled for. This evidence suggests referred workers earn higher wages not because of higher unobserved ability or better matches but rather because they are hired in high-wage sectors.

This paper develops an equilibrium matching model in which high-wage firms rely on referrals to fill jobs. Referrals lower monitoring costs since high-effort referees can exert peer pressure on co-workers, allowing firms to pay lower efficiency wages. The cost of using referrals is that they provide fewer contacts for workers and firms. Heterogeneity in the size of referral networks implies that while some firms and workers may prefer to use referrals, others are better off using formal methods. In equilibrium, the matching process generates segmentation in the labor market: referrals match ‘good’ high-paying jobs to well-connected workers, while formal methods match less attractive jobs to less-connected workers. Congestion externalities, however, may imply an inefficient split of firms and workers between the two search methods. This means that while well-connected workers may do well by using referrals to jump queues for good jobs, the unemployment rate would be lower if workers “at the margin” were induced to search formally.

The model suggests referred workers earn higher wages and have lower quit rates because referrals are a way of getting a good job. This paper provides new empirical evidence showing that industry-level use of referrals to fill job vacancies is correlated with industry wage premia (adjusting for worker skills). Moreover, evidence from the NLSY shows similar OLS and fixed-effects estimates of the referral premium, suggesting that unobserved ability is not accounting for the higher wages earned by referred workers. Finally, the results show that the referral premium disappears when sector dummies are included, suggesting that the referral premium is associated to sector of employment.

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