1. LABOUR MARKET SEGMENTATION
The New Approach to understanding structural
behavior and changes

2.  The classical and neoclassical theory determines the
equilibrium wage rate on the basis of external labour
supply-market and an internal firm demand. The
drawback with this analysis was that it didn’t consider
employee-employer relations; there wasn’t any unification
of the supply and demand side models of compensation
and employment.
 It was in 1986 that a detailed analysis of matched
employee-employer data was recognised

3.  Both the schools of thought leave many major labour
market policy issues- wage dispersion, income
distribution, unemployment unexplained.
 The thrust area of classical economics was on profit
maximization behaviour of both the individual and the
firm; workers maximise utility by bargaining for higher
wages and firms maximise profits by keeping labor costs
constant
 This orthodoxy was challenged on the grounds that it
ignored the institutional structure and social influences

4. THE DUALIST THEORY
 The dual labor market theory depicted a primary market
of unionized jobs with higher pay and a secondary
market of the low-paying jobs characterized by job-
instability;
 This ‘dualisation’ argument to neo-classical school was
developed in US labor market research. This division of
labor market corresponds to the empirical observed
structural wage differences unaffected by demand and
supply conditions

5.  The distinguish between primary and secondary labour
market lies in the market regulation and its feedback
mechanism-
 Primary labour market- characterized by long-term
employment contracts, career growth patterns, limited
affect of market fluctuations; in effect it does not behave
as a market
 Secondary labor market-wage level fluctuations,
manpower requirements, employment decisions effect
performance and pay scales
 Thus market regulatives are mostly operative in the
secondary sector; this gives rise to segmentation

6.  The radical approach of DUALISM to labor market theory
has been based on observed empirics of American
capitalism; i.e. political and economic forces in the
monopoly capitalist structure have given rise
segmentations(primary internal and secondary external)
and the sources of these segmentation are internal to the
economic system
 We thus define labour market segmentation as historical
processes of political and economic forces that have
brought about segregation into separate sub segments,
distinguished by behavioral rules and labour
characteristics

7. INTERNAL AND EXTERNAL LABOUR MARKET
 The internal labour market represents a
heterogeneous collection of compensation and
HR management policies that effect the growth
possibilities of the employee in the current
organisation
 ILM are basically long-term contractual
agreements; the rules are characterised by
match-specific investments, asymmetric
information, risk aversion and transaction-costs.
The agreement includes wages, hours of work,
promotion opportunities and grievance
procedures.
 These agreements, however long-term in nature
are incomplete and could be affected by
exogenous future events

8.  The external labour market represents a
collection of heterogeneous employment
opportunities available to an individual as an
alternative given the person’s current job status.
 Thus external labour market signifies the returns
to human capital and search costs involved
among potential employers; it implies fluidity in
worker movement across firms and wages being
decided by an aggregate process
 The existence of the external market implies that
hiring patterns are influenced by external forces,
i.e. worker mobility, wage bargaining power of
the labour outside the firm and market structure

9.  Thus in the SLM theory, we talk about the
existence of direct linkages between the
productive capacities of a worker and wages, job
allocation across firms depending on the human
capital and information structure between
employee and organisation
 As pointed out earlier, the segmentation
stemmed from the capitalist conduct of firms in
the 1970s, SLM theory lays emphasis on the
development of institutional constraints on firms’
behavior, and the systems of labour market
regulations
 We deal with the institutional rules that define the
segments and not individual skills that were
considered in the orthodox theory as the factor
for wage differences.

10. ABOWD, KRAMARZ AND MARGOLIS ANALYSIS
The AKM analysis considers the external market
effect as captured in the employee’s external
wage rate that depends on the labor market
characteristics and the opportunities of the
worker’s other wage outcomes.
We also define the internal-external wage
differential: the difference between what is
currently received and what is available as
alternative. It depends on the firm’s
compensation policy and the correlation of its HR
policy with that of the other firms in the market

11.  In the given equation,
 wit is the natural log of wages per unit time for individual I
in period t
 Ѳi is the individual labor characteristic, i.e. external
market features
 ψJ(I,t) is the part related to the firm or the internal forces
 Xitβ is related to individual like years of schooling,
experience, etc and is time dependent
 Here J(I,t) is the identity of the current employing firm

12.  Statisticaldecomposition of the given
equation gives us the estimated internal and
external wage rates of an individual employed
in firm j-
 =
 And the expected external wage rate is-
Thus the difference between internal and
external wage-rate is given by the jth firm
policies relative to that of other firms in the
market . An alternative to estimate direct
internal-external wage difference is to
decompose aggregate industry effects into
person and firm effects

13.  Wecan consider an alternative model to the
one given earlier as-
 Where K measures the aggregate effect of
firm-size or industry. AKM shows that the LSE
of K can be expressed as the weighted-
average of average firm and person effect-
 This can be interpreted as-by what amount
the measured person(external) effect deviates
from its average and by what amount the
firm(internal) effect differs from the average

14.  Thus AKM actually estimates a model in which
the individual effect is decomposed into a certain
permanent, non-time varying characteristic and a
part due to non-observable statistic. Similarly, the
firm effect is decomposed into effects of firm
compensation policies and another due to
seniority of posts available to insiders and
outsiders.
 The AKM analysis brings out the gap between
internality and externality for an individual i
employed in firm j at time t; whether current
primary segment employment is satisfactory or
there’re other alternatives in the external market

15. THE WAGE DYNAMICS
 The segmentation of the labour market into
‘good’ and ‘bad’ jobs outlines the existence of
involuntary unemployment
 In formal sector, firms decide upon contractual
agreements with workers; these implicit contracts
entail performance incentives, higher rents, re-
employment options and higher pays- it leads to
job rationing and creates pool of involuntary
unemployed
 Primary sector jobs are characterised by such
implicit agreements, hence remain outside the
labour market, it leads to workers falling back
into informal sector jobs

16.  Secondly, the incomplete nature of the contracts
gives rise to the dual nature of employment and
thus the ‘bad’ jobs characterised by low rents
and subsistence wages
 The variability in wage is observed as a
consequences of the institutional arrangement
rather than labour/wage flexibility
 The influences of the labour-market on firm wage
policies depends upon the internal(intra-firm)
labour market-the permanent workforce and
skilled manpower and on the other hand
unskilled markets

17.  Thus, intra-firm wage rate determination controls
the external market. In other words, market
conditions are influenced by the work-force
employed i.e. primary sector employment, the
skilled work-force deciding the wage rate with the
management- the implicit contracts give rise to a
‘pattern of wages’ in the long-run.
 In order to maintain constancy of wages, firm
takes to job-rationing. Thus the “enterprise wage
policies’ affect the wage setting and its
subsequent dynamics depending upon the
skilled labour employed and the labour market
conditions

18. EMPIRICAL ISSUES
 Although the SLM theory has gained
momentum and is now viewed as a better
explanation to wage fixing and structural
employment, there exists disparities regarding
the method of segmentation
 How far the dualist structure holds valid is still
subject of further analysis, whether it applies
in strict sense, whether labour mobility is
restrictive and is discrimination among race
and gender a dominating factor in explaining
the internal and external structures- all these
issues need further modeling along the
empirical data