It's who you know

A depressing article on inefficiencies in the labor market by Daniel Gross:

If labor markets were truly efficient, pay among workers with similar credentials would not vary much. But within groups of similarly situated workers, income inequality has risen in recent decades. What's more, [Stanford] Professor [Kenneth] Arrow said, "Observable characteristics like intelligence, education, experience and age explain only half of the difference."

To get at the other 50 percent, he ... constructed a model that views wages as functions of competitive bidding among companies ... About half of all jobs are still found through personal contacts of some sort. And the more connections you have, the more you end up being paid. Why? Companies that make judgments based solely on a resume are flying blind, to a degree. By contrast, if a job applicant once worked with a current company employee, or attends the same church as a company worker, the company can glean hints about how that applicant will perform.

On the one hand, this confirms what we all know, that networking matters and matters a lot. On the other hand, this is disappointing, since this inefficiency will reduce productivity by failing to put the best person in the best position for their skills.

What's the root cause of this inefficiency? The problem is that information is incomplete, inaccurate, and costly. A resume provides only limited data about a person's skills and lack credibility (without a background check). Formal interviews expand on the information available in a resume. Reference checks increase credibility further and provide information about reliability. But doing all of this over a broad pool of applicants can be very costly and, in the end, you will still have uncertainty about the skill set of the candidates.

Networking may be a short cut, providing information about a candidate at low cost. This information could be much more complete than information available elsewhere. For example, working with someone for five years gives you excellent information about their skills, reliability, and trustworthiness. But, the network relationship may only provide a false sense of security. For example, you have no relevant information about a friend of a friend, someone who went to the same college as you, a member of your golf club, or someone who goes to your church.

The key here is information. Where networking provides relevant information, it's a valuable resource for firms when recruiting. If the network relationship is distant and provides little information about work skills, biasing toward that person will miss more qualified candidates and hurt productivity.