Public policy ; Labor market ; Labor productivity

Peter Cappelli

English

Research Papers in Economics

108 2Q/2005, Economic Perspectives
Public policy and downsizing decisions
Peter Cappelli
Peter Cappelli is the George W. Taylor Professor of
Management at the Wharton School of the University
of Pennsylvania and Director of Wharton’s Center for
Human Resources. He is also a research associate at the
National Bureau of Economic Research.
Introduction
It may be easy to forget now, but in the 1980s, there
was an intense fascination in the U.S. with Japanese
management systems, especially with employee man-
agement. The combination of lifetime employment,
internal advancement, and related practices produced
a high commitment system in Japan that was the envy
of U.S. employers and the topic of endless seminars
offering advice to firms in the U.S. A popular joke at
the time described how three businessmen, one French,
one American, and one Japanese, had been convicted
of something especially bad and were being granted their
last request before being executed. The French business-
man asked to hear the French national anthem. He heard
it and was taken out and shot. Then the Japanese busi-
nessman was asked what he wanted. “I’d like to hear
one more time a lecture about the superiority of the
Japanese management system.” Then the American
jumped up and said, “Wait. Shoot me first.”
Since then, so thoroughly has the Japanese system
been supplanted as the model by U.S. practices that
people now tell the same joke in Japan, this time with
the Japanese manager asking to be shot before the
American businessman hears his last request of a lec-
ture about the advantages of U.S.-style restructuring.
Around the world, the ability to use layoffs to restruc-
ture companies is presented as the cutting edge in
competitive practices, based in part on testimoni-
als from U.S. employers and especially U.S.-based
multinational companies.
Arguably the only exception to the hegemony of
U.S.-style restructuring is in Europe, where it is claimed
that the flexibility that companies need to respond to
changing business demands can be achieved inside the
firm. These arguments describe a kind of “functional
flexibility” created by cross-functional work systems
and related work practices, as well as the use of contin-
gent labor that represents an alternative to “numerical
flexibility” achieved by layoffs and hiring. While there
is no doubt that functional flexibility can be useful to
firms, there is also evidence that they use numerical
and functional flexibility as complements, not substi-
tutes.1 In the U.S., for example, the use of contingent
work, especially temporary help and leased employees,
has grown along with the incidence of downsizing.
Data from the U.S. Bureau of Labor Statistics’
Displaced Worker Survey show that many employers
now say that their layoffs are driven by something other
than what had been the more typical declines in the
volume of business.2 In my experience watching com-
panies, the most common reasons for layoffs now are
attempts to meet profitability targets imposed within
the corporation or by its owners. One can think of these
efforts as an attempt to redraft the firm’s production
function: achieve lower average costs by using fewer
people in an effort to raise residual profits.
The interest in cutting workers as a means of im-
proving productivity has been accelerated and formalized
recently through the introduction of what is known
as workplace planning software. These are computer-
based models that help employers estimate employ-
ment needs by job and skill level. Arguably the most
sophisticated of these software packages, so-called
workplace optimization software, are explicitly designed
to ensure that employers know when they can start cut-
ting workers if business falls off and when they need to
start hiring them back when business improves. The “op-
timization” aspect comes from the reduction in excess
employees that the firm might otherwise be carrying
when business turns down, as well as the missed109 Federal Reserve Bank of Chicago
opportunities it might be able to capture if it was ful-
ly staffed at the point when business picked up again.
Policy issues associated with greater ease
of layoffs
There is no doubt that U.S. employers have pushed
for and taken advantage of greater ability to lay off
workers when business reasons make it expensive to
retain them. The range of business reasons for layoffs
spans business cycles, corporate restructurings of all
kinds (for example, mergers and acquisitions, chang-
es in organizational structure, disposal of operations),
new technologies that alter skill requirements, and
assorted factors that raise worker productivity. It seems
to be easier in terms of both lack of legal and regula-
tory constraints and social norms to lay off workers
in the U.S. than in any other developed country in the
world. States’ employment policies seem to be designed
to attract companies to their region by making it easi-
er for them to dismiss old workers and hire new ones.3
But it is still hard to argue with employers that say
that greater ability to lay off workers would reduce
their operating costs and make it easier for them to
restructure and adjust more quickly to changing markets.
It is also hard to argue with the notion that greater
ease in laying off workers reduces employers’ con-
cerns about hiring. Supporters of easing the remain-
ing restrictions on laying off workers sometimes say
that doing so would encourage hiring, per se, but of
course that is not literally true: Constraints on the
ability to dismiss are an additional cost, a variable or
per worker cost, that restrains the interest in hiring,
and reductions in those costs reduce the disincentives
on employers that otherwise have a need to hire.
Holding aside the fact that layoffs impose enormous
costs on employees, it would seem to be the case that
allowing firms to lay off workers is good for firms
and, as a result, possibly good for the economy in the
long run.4 Of course, arguments like these can easily
become tautological in that anything that firms say is
good for them can be seen a priori as good for busi-
ness and for the economy as a whole. In the context
of layoffs, the picture gets more complicated when
one considers general equilibrium issues. More spe-
cifically, the fallacy of composition—what is in the
interest of a single firm may not be in the interests of
all firms considered collectively—may well come
into play in the context of layoffs.
Consider, for example, the effects of work force
optimization programs that encourage employers to
cut jobs sooner in a downturn. Certainly a firm doing
so will benefit from cutting unnecessary costs. But will
these practices exacerbate downturns in the business
cycle by encouraging firms to cut more workers
more quickly? The point of these new programs is to
do precisely that. Can they, for example, turn what
might otherwise be a modest slowdown in the econo-
my into something more severe as workers are tossed
out of jobs and consumption begins to fall? At least
conceptually, the answer would seem to be yes, al-
though we have no idea what level and speed of layoffs
would be required to make that happen.
Rehiring and retention
The fact that firms can more easily cut workers
when they are no longer needed creates problems when
firms decide to rebuild, expand, or otherwise hire
workers back. Before the 1980s, layoffs were virtually
always business cycle related and temporary. When
business revived, firms would rehire their laid-off
employees. Unemployment insurance and supplemental
unemployment insurance benefits provided typically
through union contracts offered a financial cushion
during the period of layoff. Now, layoffs are much
more likely to be permanent, because the causes are
much less likely to be temporary. Because layoffs are
no longer based on seniority and the causes no longer
are limited to business cycles, the jobs that are vacat-
ed are not just entry-level jobs but likely span the
spectrum of skills and experience.
Once the layoffs are completed and firms need
to rehire for existing lines of business or move into
new ones, they are unlikely to want their old workers
back since job requirements may have changed and
the laid-off workers by this point have moved on. Because
the firms need to hire across the spectrum of skills and
experience, it is unlikely that they can meet their skill
requirements by hiring inexperienced entry-level work-
ers. Indeed, anecdotal evidence suggests that most em-
ployers want applicants with a minimum of three to
five years of experience who have been doing roughly
similar work to what is required in their new position.
Where can employers find such applicants? Some
may have been laid off and be looking for work, but
employers have no particular preference for these ap-
plicants. Most people who are hired into new jobs
leave old ones. The biggest source of these new hires
is other employers. When employers hire from competi-
tors, they create retention problems for each other.
Voluntary turnover, therefore, seems to be related to
layoff-driven, involuntary turnover, albeit with a time
lag.5 Retention is the biggest labor market concern that
employers report. Even the difficulty in finding good
candidates for jobs could be mitigated if employers
did not have so many retention-related vacancies to fill.
If layoffs contribute to retention problems, then
a simple solution might seem to be that employers110 2Q/2005, Economic Perspectives
worried about retention should cut back on layoffs to
reduce the need to hire later. The problem with this
view is that retention problems are in fact driven by
externalities created by other employers. The decision
by other employers to restructure creates the need to
hire from the outside to fill new vacancies, and that
outside hiring drives retention problems at the origi-
nal employer. Another obvious solution is to raise
wages to a level that will prevent employees from
leaving. To do so, however, may mean raising wages
significantly to match the level of the most desperate
employer in an increasingly broad and well-informed
labor market. When employees are not identical and
when knowledge of a competitor’s systems is impor-
tant, it is quite likely that the value of a current em-
ployee to an outside competitor may be considerably
greater than what the original employer can afford.
Why are retention problems an issue for the econ-
omy? They do more than simply add recruiting and
hiring costs and contribute to frictional unemployment.
They break down internal labor markets and the mutual
investments associated with them. Internal labor markets
provide a means for employers to screen internal can-
didates for new positions, as well as a means for re-
couping investments in employees, both general and
firm-specific investments. Voluntary turnover reduces
the average tenure over which an employer can recoup
those investments. While an employer may have the
incentive and ability to offer employees a premium to
retain their firm-specific skills, employees may quit be-
fore those skills are acquired. And few skills turn out
in practice to be truly firm-specific. Indeed, the most
highly desirable candidates may be ones with the
most detailed knowledge and experience with a com-
petitor’s practices, because they provide competitive
intelligence as well as the ability to perform the job.
There are no simple ways to calculate the costs
associated with these employee retention issues. Esti-
mates of employee turnover, which capture part of the
costs of retention, vary widely. Several experts in hu-
man resource accounting suggest at least the equivalent
of one year of compensation for each employee who
has to be replaced. In jobs where firm-specific human
capital is involved, the costs can be dramatically higher.
Even a modest increase in voluntary turnover can there-
fore amount to a sizable cost increase for employers.
Employer concern about retention issues has re-
surfaced now that employers have begun to expand
hiring again. My sense is that much of the current
concern about “labor shortages” in the face of a rea-
sonably high national rate of unemployment stems
from retention problems that are increasing the need
to hire. Employers’ concerns about retention would
be even greater if they could accurately assess the com-
plete costs associated with employee turnover and
hiring. The complication for employers is that their
own control over employee tenure is severely limit-
ed. They do not see a connection between their own
decisions to lay off employees and their subsequent
retention problems.
When we think about public policy, however, it
is important to make those connections clear. Policies
that make it easier for employers to dismiss workers
also contribute to retention problems through the log-
ical chain of restructure-dismissal-rehire-voluntary
quits. Therefore, it remains an empirical question as
to whether increasing the ease with which employers
can lay off workers is truly in the firms’ own interest.
Finally, the greater ability of employers to lay off
workers and the subsequent retention problems this
generates have affected the balance of power between
employers and employees. Employers appear to have
gained dramatically more control and influence over their
employees during periods when they are restructuring,
but especially during downturns in the economy when
employees everywhere, not just those at the bottom of
the seniority distribution or those in failing companies,
fear the pink slip. Karl Marx’s notion of the “reserve
army of the unemployed” providing a threat to employ-
ees who still have jobs seems to be alive and well,
because employers in periods of downturns are both
able and willing to require increased working hours and
work effort among those who remain on the job.
On the other hand, in periods of economic ex-
pansion and tighter labor markets, the shoe is on the
other foot as employers watch their employees hop
to opportunities at other firms, typically for wage in-
creases. In part, employees may move to other firms
out of resentment about how they were treated during
the economic downturn. It may be as much of a push
as it is a pull. Whatever the reason, retention falls as
talent walks out the door. In my experience, human
resource departments are now more concerned about
retention than they are about handling layoffs. Having
a booming economy, something one would think would
be terrific for firms, is no longer an unmitigated good,
and a recession now has much more of a silver lining
for them, at least from the perspective of the human
resources department. For employees, economic down-
turns are now much more catastrophic, because more
workers are laid off more quickly with less chance of
being rehired, while those who remain employed
find their employment conditions worsening. But up-
turns are now much more advantageous, as employ-
ers bid not only for entry-level help, as they have in
the past, but also for experienced workers.111 Federal Reserve Bank of Chicago
NOTES
1For a description, see Cappelli and Neumark (2004).
2Interesting analyses with these data can be found in Farber (2003).
3The website of the National Governors’ Association, www.nga.org,
 Social, Economic, and Workforce Division provides information
on state-level policies concerning layoffs, training, and other hir-
ing-related subsidies.
4The interests of employees obviously run in the opposite direc-
tion. Balancing those interests is a question of priorities and val-
ues, a political question of considerable importance but one that
is beyond the scope of this article to address.
5Further, employee layoffs, especially if they are handled poorly,
may cause some employees to begin to search for new jobs at
other firms for fear that their own jobs may be cut. In this sense,
layoff decisions can contribute directly to retention problems at
the same firm.
REFERENCES
Cappelli, Peter, and David Neumark, 2004, “Exter-
nal churning and internal flexibility: Evidence on the
functional flexibility and core-periphery hypotheses,”
Industrial Relations, Vol. 43, No. 1, Winter, pp. 148–182.
Farber, Henry S., 2003, “Job loss in the United
States, 1981–2001,” National Bureau of Economic
Research, working paper, No. 9707.

External churning and internal flexibility: Evidence on the functional flexibility and core-periphery hypotheses,”

Public policy and downsizing decisions

http://www.chicagofed.org/digital_assets/publications/economic_perspectives/2005/ep_2qtr2005_part10_cappelli.pdf

Public policy and downsizing decisions

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics