The Limits of “Up-or-Out”: Which Promotion Practice Pays off the Most for Firms

Both psychologists and economists know that a high position within an organization and the associated social status is more important for most people than just a rise in income. The prospect of promotion is a crucial incentive that firms can utilize to improve productivity among their employees as well as to save salary costs. In a recent publication* in the Journal of Economic Behavior & Organization, Guido Friebel, Professor of Human Resource Management at Goethe University Frankfurt, analyzes together with Emmanuelle Auriol (Toulouse School of Economics) and Frauke von Bieberstein (University of Bern) which type of promotion practice is optimal for a firm.

The authors develop a model which compares a standard promotion practice with an “up-or-out” system. In both hierarchies, workers have the opportunity to gain additional status by being promoted upon a success. Only in the second, however, workers who do not earn a promotion have to leave the firm after a certain period of time. People can chose between working in one of these hierarchies and a low-status self-employment. The promotion incentives ensure that productive workers prefer the firm over a self-employment. By offering the prospect of higher status and salaries, firms can pay junior workers wages below the output they produce and thus make profit.

Comparing both hierarchies, the authors find that, in terms of firm profits, up-or-out is always optimal if it is very difficult for workers to achieve a success that leads to promotion. When success is less hard to achieve, it depends on the payoff associated with success. If it is high, up-or-out is again optimal for the firm; if payoff is small enough, standard promotion practices turn out to be better. The reason is that workers take the risk of up-or-out only when they are offered sufficiently high incentives with respect to promotion and salary rise. A firm that cannot offer a respective promotion is better off with a standard promotion practice because, otherwise, it would need to offer higher increase in salary in order to attract productive workers.

"Our model explains why up-or-out hierarchies can be found in certain sectors such as science or consulting where big successes are rare but highly rewarding and a promotion to a professorship or partnership entails a massive gain in status," explicates Guido Friebel.

* Auriol, E., Friebel, G., von Bieberstein, F. (2016): “The firm as the locus of social comparisons: Standard promotion practices versus up-or-out”, Journal of Economic Behavior & Organization, Vol. 121, pp. 41-59.