Market frictions and the competitive advantage of internal labor markets

Research summary: We show that frictions in labor and capital markets can be a source of competitive advantage for affiliates of corporate groups over stand-alone firms in environments where benefits from internal markets' flexibility are high. We argue that the advantage of flexibility in changing labor inputs is related to how difficult it is to change capital inputs. We predict that if substituting labor with capital is difficult, the group advantage of flexibly changing labor would be stronger in countries with high levels of financial development. Consistent with this prediction, we find a stronger competitive advantage for group affiliates in countries with rigid labor markets but flexible capital markets. In these environments, group affiliates are more prevalent and outperform stand-alone firms in terms of growth and profitability. Managerial summary: This research shows that the capacity to redeploy workers across internal units of the firm can be a source of competitive advantage in countries that impose strict employment protection laws. We show that the strategic advantage of labor flexibility is affected by how difficult it is to change capital inputs and that labor flexibility is a stronger source of competitive advantage in countries where developed financial markets allow for more flexible capital adjustment. In these settings, strategies designed to lower costs of internal mobility (e.g., locations of greater geographic concentration between units and in regions with less competitive external markets), development of corporate culture supportive of frequent change, and personnel development through internal rotation can result in substantial financial payoffs. Copyright © 2015 John Wiley & Sons, Ltd.