Internal and External Labor Markets: A Personnel Economics Approach

Internal labor markets are those where workers are hired into entry level jobs and higher levels are filled from within. Wages are determined internally and may be quite free of market pressure. External labor markets imply that workers move somewhat fluidly between firms and wages are determined by some aggregate process where firms do not have significant discretion over wage setting. There are a number of theories that lead to internal labor markets. Using data from Sweden from the late 1980s, it is found that although there is significant evidence of internal promotion being important, a significant external market exists that affects both wage setting and hiring patterns. Even in Sweden, which most would not choose as the best example of a free labor market, external factors seem to create strong discipline on the ability of firms to set wages.