Works by Chandler (1962) and Penrose
(1959) emphasize the importance of labor resources for firm performance and
growth. Scholars have examined the economic effects of efficient allocation of
labor (e.g., Nickell & Layard, 1999; Castanias & Helfat, 1991, 2001), but
research on how labor management builds competitive advantage and shapes a firm
is scarce. Our interest is in the conditions under which internal labor markets
(ILMs) are likely to form. ILMs can shape firm boundaries, supporting the view
of ILMs of large corporations as key to long-term success. We examine the
importance of ILMs in the European Union through the combined effect of country
labor regulations and industry conditions on firms’ strategic choice of
organizing.
The institutional void theory (Leff,
1978) emphasizes the central role of firms in replacing missing or
dysfunctional external markets. By organizing in corporate groups, firms
benefit from a regulation-free internal labor market when adjusting their labor
force. When markets inefficiently allocate labor across firms, the ILMs of
large organizations can gain a more prominent role in such allocation
activities (Spence, 1975; Leff, 1978; Khanna & Yafeh, 2007). We test the
effect of ILMs on group affiliation and the relationship between industry-level
labor turnover and country-level employment protection.
Why the EU? The European Union is an ideal environment
for testing the ILM theory because its employment protection varies widely
across countries. Employment protection regulations include legal rules,
administrative procedures, and compensatory payouts that apply to employee
dismissals. Unlike unemployment benefits, which are funded through taxes,
employment protection regulations impose direct costs on the employer
responsible for dismissals. For example, in Spain, dismissal procedures require
30-day written notice with a statement of reasons for dismissal and a written
notification to the worker’s representatives at the workplace. Spanish
employees are also entitled to severance pay equivalent to 33 days’ salary for
each year of service. Similarly, Austrian workers with more than 3 years of service
are entitled to 8 weeks’ notice and 6 months’ salary as severance pay (OECD
Employment Outlook, 2004). Strict regulations effectively raise costs of
terminating redundant or underperforming workers.
Corporate group exemptions: Under European Union law, however, worker
movement within a corporate group is not considered a “market transaction.”
This means that intra-group mobility is not subject to country labor-market
regulations. The European Union Directive 96/71/EC grants group affiliates an
exception that allows the transfer of employees among affiliates without having
to dismiss and rehire each transfer – and therefore without being subject to
employment protection regulations. Although it is important to note that there
could be other costs contributing to labor adjustment costs, we focus on labor
market regulations as highly costly in terms of lost productivity and limited
growth. We would therefore expect more economic production within a country to
be organized in corporate groups, where labor redeployment costs are muted.
Our paper also contributes to the
large literature that studies the economic consequences of market regulation
policy. Labor regulations have received special attention as a major source of
costly market tension in the European Union (EU), where the popular press has
recently argued that the sluggish growth is in fact the direct result of
stringent employment regulation policy. We contribute to this debate by
highlighting a critical strategic response of firms that can substantially reduce
the productivity losses caused by extensive labor market regulations – namely,
organizing labor market transactions within rather than between independent
firms.
Empirical strategy: By comparing organization structures
in 15 Western European countries, we examine how institutional differences
affect whether firms form corporate groups. We examine the impact of high and
low restriction of labor regulations on the difference in share of firms
affiliated with a group between industries with high and low labor turnover. We
focus on a set of economies which: i) share a clear and consistent definition
of groups; ii) exist within a narrow range of economic development, such that
we can separate developing and developed economies in our study; and iii) vary
enough in the level of labor regulations and represented industries so that we
may observe the impact of the interaction between industry labor turnover and
country labor regulations.
We rank industries according to their
level of labor turnover, using 1977–2003 data from the U.S. Bureau of Labor
Statistics to calculate the average turnover rate for each industry. Then we
rank the 15 countries in our sample according to the level of their employment
regulations using the OECD Employment Protection Index and complementary
measures. The index ranges from 0 to 6 (least strict to strictest) and takes
into account indicators for regular employment, temporary employment, and
collective dismissals. Though our focal countries are relatively wealthy and
enjoy developed legal environments, they nonetheless exhibit measurably
different levels of employment regulations. Greece (3.11), Spain (3.01), and
France (2.88) are countries with the strictest employment protection
regulations, while Great Britain (1.07), Ireland (1.25), and Switzerland (1.60)
have the fewest restrictions on employee dismissals.
Findings: Our findings strongly support the
internal labor markets hypothesis. Industries with high labor turnover have
disproportionately more group-affiliated firms than low-turnover industries,
especially in countries with high employment regulations. Importantly, we find
that the relevant measure of country regulation is the extent to which firms
face job termination restrictions, whereas we find no effect for country
unemployment protection. This is consistent with the view that firms organize
as corporate groups partly as a response to increased country regulations on
labor mobility. Consistent with the ILM theory, we find stronger effects when
comparing standalone firms to firms that are affiliated with larger and more diverse
groups. We also note that, where labor regulation and employment turnover are
quite high, both large size and active internal labor markets may be a source
of long-term competitive advantage.
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