Employee referrals and efficiency wages

Abstract

Many workers believe personal contacts are crucial for obtaining jobs in high-wage sectors. On the other hand, firms in high-wage sectors report using employee referrals to screen and monitor new employees. This paper develops a matching model that can explain the link between inter-industry wage differentials and 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 contacts than formal methods. In equilibrium, referrals match 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 premiums and employee referrals. Moreover, evidence using the National Longitudinal Survey of Youth (NLSY) shows similar OLS and fixed-effects estimates of the ‘returns’ to employee referrals, but insignificant effects after controlling for sector of employment. This evidence is more consistent with an efficiency wage explanation than either an ability or matching explanation of referrals.