Internal labor markets with two types of promotion and two tiers of salary: theory and evidence from China

This paper shows the optimality of a two-tier linear salary scheme in internal labor markets and identifies conditions under which discretionary promotion is better than rule-based promotion and vice versa. Our main findings are: (1) regardless of whether discretionary promotion or rule-based promotion is used, a two-tier salary scheme is optimal; (2) the salary is contingent on promotion, which is fixed before and linear after promotion; (3) if the difference in human capital among agents is small, discretionary promotion is superior; (4) if the expected replacement cost of human capital is high, discretionary promotion is superior; (5) if the risk of facing/incurring a high replacement cost of human capital is high, discretionary promotion is superior; (6) if the chance of having a high human capital agent is high, rule-based promotion is likely to be superior; and (7) if the productivity improvement from a job promotion is large, rule-based promotion is likely to be superior. We have also found empirical evidence in support of our theory on the two-tier salary scheme.