ECON 3123

Promotions as Incentives
Hongyi Li
October 2016

This lecture is about the relationship between two important organizational issues:
Human Capital Acquisition, i.e. the acquisition of productive skills (i.e. training) by
workers, and
Internal Labor Markets, i.e. the promotion and pay policies within organizations.
Well focus on the idea that internal labor markets are designed to motivate human capital
acquisition by workers. The idea here is that workers may acquire skills that increase their
productivity within the firm; and the firm may motivate workers to invest in such skills by
setting up a system where workers who acquire skills are promoted to higher-paying jobs.
Well explore three models which highlight the issues involved in designing such promotion
schemes. Throughout our discussion, well assume that the cost of training / skill acquisition
is borne by the worker instead of the firm.
In reality, the cost of skill acquisition is probably shared between the firm and the worker.
So, we may think of the models in this lecture as focusing on how the firm may motivate
the worker to acquire skills. There is a separate set of interesting issues, relating to
whether firms are willing to invest in training for their workers, that we do not touch
on.

Promotions as Incentives
As we will see, the problem that organizations face in these models is one of commitment;
this is essentially the same problem we encountered in the one-shot trust game.
The basic idea, described in a principal-agent framework, is this: a principal (the firm)
wants an agent (the worker) to put in effort into acquiring skills that make the agent
more productive.
However, the firm cannot credibly commit to rewarding the agent for skill acquisition.
This is because skill is often difficult to describe precisely. As a result, there is no good
measure of skill acquisition that can be easily written into a contractual agreement,
so the principal cannot credibly offer the agent an incentive scheme of the form I will
pay you $ X if you acquire skill Y that motivates the worker to acquire these skills.
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 As in the one-shot trust game from Lecture 4, the problem is that the principal is
tempted to renege on rewarding the agent after the agent has invested in skill acquisition.
Anticipating this, the agent will choose not to invest in skill acquisition at all.
In this section, well show how certain organizational policies are in fact indirect ways
for a firm to commit to rewarding its workers for skill acquisition.
Many firms use promotions to incentivize workers to work hard. The idea is that there are
different jobs within the firm, and that different jobs are paid different wages. The firm may
then motivate workers by promoting workers who perform well to higher-paying jobs.
The focus of this lecture will be on how a firm can design promotion schemes that overcome
the commitment problem and thus induce the worker to exert effort in equilibrium. Well go
through three models that illustrate different aspects of such promotion schemes.

A Simple Model of Promotions

Lets start by writing down a very simple model of such promotion-based incentives. Well
focus on the idea that the wage differential between jobs can be used to provide incentives to
workers.
In this model, well introduce the commitment problem and show how it may prevent
the firm from successfully motivating the employee to exert effort. (In the next model,
we will show how it can be solved.)
Unlike the models from last lecture, well ignore labor market competition. (This will
simplify the model and allow us to focus on other issues; well discuss how labor market
competition may affect our results at the end of this section.)

1.1

Model Setup

There is a worker (agent) employed within a firm (principal), who works for a single period.
The agent is initially unskilled (s = 0), but can choose to acquire skills (s = 1) at cost c. The
worker, not the firm, bears the cost of training.
The firm seeks to maximize its expected profit: Uf irm = E[y w]. The worker seeks to
maximize his expected wage minus any effort costs: Uworker = E[w sc].
Note that the effort cost equals zero if the worker doesnt acquire skills (s = 0 implies
sc = 0), whereas effort cost equals c if the worker acquires skills (if s = 1, then sc = c).
The firm has toassign the worker to one of two jobs, A or B. The firm chooses which job to
assign the worker to.
The productivity of the worker in either job depends on his skill level.
A skilled worker is more productive than an unskilled worker. Specifically,
An unskilled worker produces profit y = yL for the firm no matter what job he is
assigned to.
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 A skilled worker produces profit y = yH > yL for the firm no matter what job he is
assigned to.
Think of these skills as being purely firm-specific; they do not improve the workers
productivity if he leaves the firm. This will not matter in the model for now, but
keep it in mind for the discussion of labour market competition at the end of this
section.
The increased productivity from training exceeds the cost of training: yH yL > c. This
implies that the efficient outcome (i.e. the set of choices that maximize total utility Uf irm +
Uworker ) is to have the worker choose to train.
Well make the simplifying assumption that wages are fixed (i.e. the firm has no control over
the wages for each jobs), and that job B is more lucrative for the worker than job A: the
wage associated with job A is fixed at wB while the wage associated with job B is fixed at
wB , with yH yL > wB wA > c.
Note that were assuming that job Bs wage exceeds job As wage by more than the cost
of training c; this assumption seems arbitrary but will be necessary to make our point.
Later, in the next section, well relax this assumption and look at how the firm will
optimally assign wages for each job.
To summarize, the timing of the game is:
1. The unskilled worker chooses whether to incur the cost of training. If he does, then he
becomes a skilled worker.
2. After observing whether the worker is skilled or unskilled, the firm chooses which job (A
or B) to assign the worker to.

1.2

Equilibrium Outcome

Lets solve for the equilibrium of this sequential game.

As usual, we solve backwards.
First, consider the firms decision in step 2 over which job to assign the worker to.
The firm seeks to maximize net profit Uf irm = y w. At step 2, y has already been
determined by the workers choice of whether to train; the workers productivity is
the same regardless of which job he is assigned to. So, the firm maximizes profit by
minimizing the wage w paid to the worker.
This is done by assigning the worker to the lower paying job A. This is regardless
of whether the worker invests in training in step 1.
Anticipating that he will always be assigned to the lower-paying job A, the worker will
then optimize in step 1 by choosing not to train. (This is because his wage will be the
same regardless of whether he trains or not.)
So, in equilibrium, the worker will choose not to train, and the firm will always choose to
assign the worker to the lower-paying job.
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 Now, suppose that instead of always assigning the worker to the lower-paying job A, the
principal can be forced to play the following strategy:
If the worker chooses to train, then assign the worker to job B.
If the worker chooses not to train, then assign the worker to job A.
What is the workers best response to such a strategy?
The worker anticipates that if he chooses to train, then he will be assigned to job B; so
his net payoff from training is Uworker = wB c.
On the other hand, if he chooses not to train, then he will be assigned to job A, so his
net payoff from not training is Uworker = wA .
Which choice makes the worker better off?
Remember our earlier assumption that the job Bs wage exceeds job As wage by
more than the cost of training c: wB wA > c. This condition ensures that wB c >
wA , i.e. the worker prefers to train and be assigned to job B, rather than not to
train and be asigned to job A.
Thus, the workers best response is to train.
This means that, in our model, a key obstacle to achieving the efficient outcome (i.e.
getting the worker to train) is the inability of the firm to commit to a strategy that
rewards the worker for training (and conversely, punishes the worker for not training)
by promoting him to the higher-paid job.

1.3

Discussion

Note that this logic is identical to that of the one-shot trust game; in that model, the agent
would trust the principal if the principal could commit to cooperating with the agent, but
since the principal is unable to make such a commitment, the agent chooses not to trust the
principal.
So, this model of promotion is really the trust game in disguise.
Now, lets take a step back and examize the assumptions we have made to reach the conclusion
that the firm cannot induce the worker to train.
One assumption weve made is that the principal doesnt get to choose the wage associated
with each job. Would our conclusion (that the agent will not choose to train in equilibrium)
change if, at the start of the game (before step 1), the principal was able to choose the wage
for each job?
Another assumption weve made is that there is no labor market competition.
This assumption turns out to be justified if skills are purely firm-specific in that case,
our conclusions wouldnt change even if there is competition in the labour market.
On the other hand, if skills are instead general-purpose, then labour market competition
may discipline the firm and force it to reward the agent for skill acquisition.

 A more important assumption is that the effect of training on productivity is the same for
both jobs. This is reflected in the assumption that regardless of which job he is assigned to,
his productivity is yL is he is unskilled and yH if he trains and becomes skilled.
One way to think about it is that in this model, the jobs are actually identical (i.e. the
worker is performing the same tasks in both jobs), and differ only in the job title.
Sometimes this assumption makes sense: in some organizations, jobs really are nothing
more than labels.
For example, in academia, junior professors and senior professors often do the same
thing (teaching + research), although of course there will typically be differences
in skill level between the average junior professor and the average senior professor.
To some extent, this is also true in professional service firms such as law firms.
On the other hand, there are many situations where this assumption isnt realistic. For
example, consider an organization where there are two types of jobs: clerical jobs and
managment jobs. Then we may expect that in each type of job, more skilled workers are
more productive, but (importantly) that the increase in productivity from being skilled
is more pronounced in the managerial job than in the clerical job. In other words, skills
are more important in the managerial job than in the clerical job.
It turns out that when skills have different impacts on different jobs, firms may be able
to successfully commit to rewarding skill acquisition via promotions. This will be the
focus on our next section.

Job Assignment and Skill Acquisition

In this section, well modify the model from the last section; in particular, well introduce
differences between jobs.
As before, there is one worker, one firm, and two possible job assignments. The worker is
initially unskilled (s = 0) and can choose to acquire skill (s = 1) at cost c.
Also similarly to the last model, the firm seeks to maximize its net profit, Uf irm = y w (i.e.
workers output, minus wages paid to worker) while the worker seeks to maximize the utility
function Uworker = w sc (i.e. wage received, minus cost of training.)
The differences from the model of the last section are:
The workers productivity depends on his job assignment as well as his skill level. We
may identify one job as (E)asy and the other job as (D)ifficult. Let yD (s) be the workers
productivity in job D if his skill level is s, and let yE (s) be the workers productivity in
job E if his skill level is s.
Our key assumption is that skill is less important for the (E)asy job than the (D)ifficult
job: specifically,
yD (0) < yE (0) < yE (1) < yD (1).
(1)
Whereas we previously assumed that the firm has no control over wages, we now assume
that the firm gets to set the wages for each job. Let wD be the wage that the firm
chooses for job D and let wE be the wage that the firm chooses for job E.
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 Finally, let the agents outside option equal U0 .

The timing of the game is:
1. The firm commits to a set of wages, one for each job: wD and wE .
2. The worker decides whether to stay or quit. If he quits, he receives his outside option
value U0 .
3. The worker chooses whether to train, i.e. he chooses either s = 0 or s = 1.
4. The principal chooses which job (D or E) to assign the worker to.
As before, we are interested in the case where the efficient outcome involves training (s = 1).
But the equation representing this case is now slightly different:
Training is efficient if and only if the difference between an unskilled workers maximum
productivity and a skilled workers maximum productivity exceeds the cost of training
c.
An unskilled workers maximum productivity is achieved when he performs the easy task
(because yE (0) > yD (0)), while a skilled workers maximum productivity is achieved
when he performs the difficult task (because yD (1) > yE (1)).
So, the condition for training to be efficient is
yD (1) yE (0) > c.

(2)

Well assume that this condition holds.

2.1

Equilibrium Outcome

OK. Now, lets work out conditions under which the worker chooses to train (s = 1) in
equilibrium.
Recall that in the model from the last section, the firm was unable to induce the worker
to train because the firm would always optimize by assigning the worker to the low-paying
job regardless of his skill level (which meant that the worker had no incentive to invest in
training).
In the current model, however, it may be in the firms own interest to assign skilled and
unskilled workers to different jobs. This is because the effect of skill on productivity differs
across jobs: skilled workers perform better at job D than at job E. Thus, as long as the job
D wage is not too high compared to the job E wage, the firm will optimize by assigning a
skilled worker to job D and an unskilled worker to job E.
Specifically, the firm will perform such an assignment if yD (1) wD > yE (1) wE , or
equivalently (by rearranging terms) yD (1) yE (1) wD wE .
Suppose that this condition is satisfied; so, in step 4, the firm assigns the worker to job D if
he has trained (s = 1), and to job E if he hasnt trained (s = 0). Then under what additional
conditions will the worker choose to train?

 The workers payoff from training is wD c, while his payoff from not training is wE . So
he chooses to train if and only if wD c wE , or equivalently (by rearranging terms)
wD wE c.
So, combining the two conditions, we get that the worker can be induced to train if and only
if
yD (1) yE (1) wD wE c.
(3)
In other words, in order to induce the worker to train in step 3, the firm must choose wages
in step 1 so that the wage gap wD wE is not too small and not too large:
If the wage gap is smaller than the cost of training (i.e. if wD wE < c), then the agent
will not find it profitable to train.
If the wage gap is larger than the productivity gap for a skilled worker between the two
jobs (i.e. if wD wE > yD (1) yE (1)), then the principal will be tempted to assign a
skilled worker to job E; consequently, the worker will not train because he anticipates
that he will be assigned to the same job E (and thus receive the same wage) regardless
of whether he trains.
In particular, this means that the worker can be induced to train if and only if
yD (1) yE (1) c;

(4)

otherwise, wages cannot be chosen so that the wage gap lies between c and yD (1) yE (1).
Now lets return to step 1, and figure out the firms equilibrium choice of wD and wE .
Suppose that the inequality (4) is satisfied, so the firm can induce the worker to train
by choosing wages appropriately. What set of wages wD and wE will the firm choose,
to maximize profits?
The firms choice of wages must ensure that the worker receives at least his outside
option utility level U0 .
Remember that were looking for an equilibrium where the worker chooses to train,
which means that he will be assigned to job D. So, the firm has to ensure that
wD c U0 ; or equivalently, wD U0 + c.
The firm maximizes net profit by setting wD as low as possible while still ensuring
that the worker achieves his outside option utility level; thus it chooses wD = U0 + c.
As for wE , the firm simply has to choose wE so that Equation (3) is satisfied;
given wD = U0 + c, any such choice of wE will do. (For example, it can choose
wE = wD c = U0 .)
The firms net profit from choosing such a wage scheme is then Uf irm = y w =
yD (1) (U0 + c).
Next, suppose that inequality (4) is violated, so the firm cannot induce the worker to
train no matter what wage scheme it offers.
In this case, the anticipates that the worker will never train, and it will always assign
the worker to job E (this is where the unskilled worker is most productive).
In this case, it will choose wE = U0 to ensure that the worker receives at least his
outside option utility.
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 The firms net profit from choosing such a wage scheme is then Uf irm = y w =
yE (0) U0 .

2.2

Discussion

Suppose the efficient outcome is for the worker to train. Can the firm induce the worker to
train whenever this is the case?
No.
Recall that the condition for training to be efficient is yD (1) yE (0) c, which is
not the same as the condition that makes it possible to induce the worker to train
(yD (1) yE (1) c).
In particular, suppose that training is efficient (yD (1) yE (0) > c) but that the increase
in productivity in the easy job from training (yE (1) yE (0)) is very large. Then yD (1)
yE (1) = (yD (1) yE (0)) (yE (1) yE (0)) will be small, so that it will be impossible to
induce the worker to train.
In other words, under certain circumstances, it may be impossible to induce the
worker to train even if training is the efficient outcome.
The reason training sometimes cannot be induced stems from a conflict between the firms
commitment problem and the workers motivation problem.
To get the worker to train, the firm has to credibly commit to promote workers to the
difficult job if and only if they are skilled. For such a commitment to be credible, the
wage gap (i.e. the difference in wages between the difficult and easy jobs) cannot be
too large; otherwise the firm would be tempted not to promote skilled workers to the
difficult job, so as to save on wages.
But at the same time, the wage gap has to be large, so as to motivate the worker to
train.
When these two constraints conflict with each other, the firms commitment problem
and the workers motivation problem cannot simultaneously be resolved, resulting in a
no training outcome.

Up-or-Out Promotion Schemes and Human Capital Acquisition

Combining the lessons from the last two sections tells us that simple promotion schemes of
the type proposed in those models may be ineffective unless different jobs involve different
tasks.
Yet, as weve mentioned, in many firms, junior and senior employees perform basically the
same tasks (although potentially with different skill levels). How can such firms induce their
employees to acquire firm-specific skills?
One interesting feature of promotion schemes in academia and in many law firms, consulting
firms, etc is the Up-or-Out scheme:
If promotion does not occur within some set period, the individual is not retained.
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 For e.g., achieving tenure in academia, making partner in law and consulting firms.
Recall the probationary system from last lecture; we may think of Up-or-Out as another
form of probation.
The model of probation from last lecture was about how probationary schemes can be
used to screen for high-quality hires, and deter low-quality workers from joining the firm.
In contrast, the focus of this model will on a different role of these probationary schemes:
to induce workers to invest in firm-specific human capital.
Lets write down a simple model where workers have a choice of whether to acquire firmspecific skills, and the firm seeks to design an incentive scheme to induce such acquisition.
A key element of the model will be that although the principal cannot commit to rewarding
the worker for skill acquisition, he can commit to an Up-or-Out scheme where he has to
choose between retaining the worker at a predetermined wage, or firing the worker.
Importantly, this means that in the Up-or-Out scheme, the firm commits not to offer
the worker a lower wage (than what was previously agreed on) to stay on, even if such
an agreement would be more profitable for the firm.

3.1

Model Setup

There is a worker within a firm. As in the other models in this section, the worker is initially
unskilled.
The worker can train, at cost c > 0.
We write that t = 1 if the worker trains, and t = 0 if he does not train.
Training is not necessarily successful; specifically, it is successful with probability 0 <
p < 1 (the worker pays the cost c even if the attempt is unsuccessful).
If the workers training is successful, then he becomes skilled; if his training is unsuccessful, he remains unskilled.
Unlike the last model, there is only one type of job within the firm. This means that the
workers productivity within the firm depends solely on his skill level. Specifically: an unskilled worker produces profit y = yL for the firm, while a skilled worker produces profit
y = yH > yL for the firm.
Well assume that the average increase in productivity from training exceeds the training
cost: p(yH yL ) > c.
The workers outside option value is U0 ; this value does not depend on whether the worker is
skilled or unskilled (so we can think of the skill as being firm-specific). Further, we assume
that the worker is always more valuable within the firm than outside: that is, yL > U0 (which
also implies that yH > U0 ).
As before,
The firm seeks to maximize the expected value of net profits, Uf irm = E[y w].
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 The worker seeks to maximize the expected value of his wage minus his effort cost,
Uworker = E[w tc].
(Note that we have to use expected values here because there is uncertainty in outcomes:
training may or may not be successful, which introduces uncertainty into workers productivity and potentially into the job allocation.)
The timing is as follows:
1. The firm commits to a wage w U0 . (This constraint is put in place to ensure that the
worker is willing to stay with the fimr rather than leave and receive his outside option.)
2. The worker chooses whether to train. If he trains, the training is successful with probability p. (The firm observes whether training is successful, i.e. whether the worker is
skilled or unskilled.)
3. The firm chooses whether to retain the worker (thus paying him wage w) or to let him
go (thus paying him zero wage).
If the worker is retained, he produces profit y (which equals yL or yH depending on
whther the worker is skilled or unskilled) for the firm, and is paid wage w. If the
worker is let go, he produces zero profit for the firm (y = 0), and receives his outside
option U0 .

3.2

The Efficient Outcome

Lets start by discussing the efficient outcome (i.e. the set of choices that maximizes total
utility, Uf irm + Uworker ).
It turns out that our assumptions ensure that the efficient outcome is for the worker to train,
and for the firm to always retain the worker (regardless of whether training is successful):
Retaining the worker is always efficient because the worker is more productive when
he is retained, even if he is unskilled: yL > U0 .
Given that the worker is retained, it is efficient for the worker to train because the
expected productivity increase from training exceeds the cost of training: p(yH yL ) > c.
Does there exist an equilibrium where this efficient outcome is achieved?
No.
Suppose the firm chooses a wage w such that in step 3, he always prefers to retain the
worker (regardless of whether the worker is skilled or unskilled).
Then at step 2, the worker anticipates that he will receive the same wage regardless of
his training choice. He maximizes his utility by choosing not to train.
So, we know that the efficient outcome cannot be achieved in equilibrium. But can we achieve
a second-best outcome? We will focus on two potential alternative outcomes:1
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In fact, there are other alternatives as well that correspond potentially to mixed equilibria of the game. But well
restrict attention to these two alternatives because they highlight the key tradeoffs involved.

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1. A full-employment outcome where the firm always retains the worker, but the worker
doesnt train.
2. An Up-or-Out outcome where the firm doesnt always retain the worker, but the worker
always trains.
Well start by analysing the Up-or-Out outcome. Specifically, well look for conditions that
the wage w must satisfy so that (i) the worker prefers to train, and (ii) the firm prefers to
retain the worker if and only if the worker is skilled. If these conditions are satisfied, well
say that the wage w corresponds to an Up-or-Out scheme.

3.3

Up-or-Out Scheme

Lets look for a wage w (chosen in step 1) that induces the worker to train in step 2.
For the worker to prefer to train rather than not train, he must be rewarded for training;
i.e. he must do better (on average) if he trains than if he doesnt train.
This occurs only if the firm plays the following pure strategy: Retain the worker if he is
skilled, and fire him if he is unskilled. (With this strategy, the worker is rewarded for training
because he has a higher chance of becoming skilled and thus being retained.)
This is why we label such a scheme as Up-or-Out: workers are retained (Up) only if
they turn out to be skilled. Unskilled workers are fired (Out) even though they may
still be productive for the firm.
Lets write down conditions which ensure that both the worker and firm will behave in the
way we describe above.
The worker must prefer to train rather than not train:
Suppose the worker trains. He anticipates that the firm will retain him if his training
is successful (which occurs with probability p), and fire him otherwise (which occurs
with probability 1 p). Also, the worker definitely incurs a training cost of c. Thus
his expected utility if he trains equals
Uworker = pw + (1 p)U0 c.

(5)

Suppose the worker doesnt train. Then he will definitely be fired. SO his expected
utility if he doesnt train equals U0 .
Comparing these two expected utilities, we infer that the worker trains if and only
if pw + (1 p)U0 c U0 , or equivalently p(w U0 ) c. We can rearrange this
inequality to become
c
w + U0
(6)
p
The firm must prefer to retain a skilled worker: since a skilled worker produces yH for
the firm, the firm prefers to retain a skilled worker if and only if yH w.
The firm must prefer to fire an unskilled worker: since an unskilled worker produces yL
for the firm, the firm prefers to fire an unskilled worker if and only if w yL .
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 Combining these conditions, we conclude that the worker will train in step 2 only if the wage
w satisfies the condition
c
yH w max{ + U0 , yL }.
(7)
p
Thus we can find a wage w to induce the worker to train if and only if
c
yH max{ + U0 , yL }.
p

(8)

Because yH > yL by assumption (i.e. a skilled worker is more productive than an

unskilled worker), this expression simplifies to become
yH

c
+ U0 .
p

(9)

Using this condition, we can show that Up-and-Out contracts may be effective at inducing
workers to acquire human capital, but only under certain circumstances:
Note that the condition can be satisfied only if p is large (i.e. if there is little uncertainty
in the outcome of training). If p is small (i.e. if training is risky), then we will be unable
to find a value of w that induces the worker to train while at the same time inducing
the firm to retain a skilled worker.
On the other hand, if c is small and p is large, then we can find w to satisfy the condition.
In particular, whenever the condition 7 can be satisfied for some range of wages, the most
profitable Up-or-Out scheme (for the firm) corresponds to the lowest wage that satisfies the
condition: w = max{ pc + U0 , yL }.
This results in expected profit E[y w] = p(yH max{ pc + U0 , yL }) for the firm.

3.4

Full-Employment Scheme

As mentioned earlier, another possibility for the firm is to commit to a wage w in step 1 that
ensures that it will always retain the worker in step 4 (i.e. Full-Employment).
Recall that in an Up-or-Out scheme, the firm commits to a high wage in order to force itself
to fire unskilled workers in step 4. No such commitment is necessary in a Full-Employment
scheme, so the firm simply chooses the minimum possible wage that satisfies the workers
outside option constraint, i.e. w = U0 . This ensures that:
The firm will always retain the worker in step 3, regardless of whether the worker becomes
skilled or not;
Anticipating this, the worker will always choose not to train in step 2.
Thus the net profit to the firm if it chooses a Full-Employment scheme with w = U0 is
E[y w] = yL U0 .

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3.5

Up-or-Out versus Full-Employment

Suppose for the rest of this section that condition (9) is satisfied; this means that by choosing
w appropriately, the firm can induce the worker to train using an Up-or-Out scheme, if it so
chooses.
Does the firm prefer an Up-or-Out scheme or a Full-Employment scheme?
This will depend on whether the Up-or-Out scheme is more profitable for the firm than
the Full-Employment scheme.
Comparing the profit expressions that weve derived for each scheme, the Up-or-Out scheme
is more profitable than the Full Employment scheme if and only p(yH max{ pc + U0 , yL }) >
yL U0 . .
We wont go into the nitty-gritty of this last condition, but we can see that if yH is sufficiently
large (i.e. if the productivity of a skilled employee is sufficiently high), then the Up-or-out
scheme is more profitable than the Full-Employment scheme, because it induces the worker
to train and thus makes output of yH more likely.

3.6

Discussion

To recap: Up-or-Out schemes may be used to induce workers to acquire firm-specific human
capital when simple promotion schemes may be ineffective.
However, they result in efficiency losses: the firm can only induce workers to train if it commits
to firing less productive workers (even though it would be profitable for the firm to retain
these workers.)
In fact, this tension is quite strong in many organizations: the Up-or-Out system in
law firms is often criticized for kicking out associates who were productive but did not
manage to be promoted to partner.
An alternative for the firm is to resort to a Full-Employment scheme, where the worker
is always retained. The drawback of a Full-Employment scheme is that such job security
makes the worker unwilling to train.
So, the tradeoff that a firm faces is that Up-or-Out does not fully utilize productive workers,
whereas Full-Employment retains productive workers but fails to motivate them to acquire
useful skills.
An additional drawback of Up-or-Out, from the firms perspective, is that it has to pay the
worker a high wage (w > c/p + U0 ) in order to motivate the worker to acquire skills.

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