# 5. War For Talent

Published onSep 19, 2022
5. War For Talent

# Abstract

How can human resource management help organizations to staff their organizations with talented employees in times of labor market shortages?

Key Theories
(Neo)Classical wage theory
Efficiency wage theory
Internal labor markets (ILM) and transaction costs
Equity and justice theories
Expectancy theory
Psychological contract theory

Key HR Practices
Compensation
Employee segmentation
Recruitment
Onboarding
Performance appraisal
Talent management

In the nineties, McKinsey consultants announced that the future competitive power of organizations would not depend on having the best products, services or prospects, but on the ability to attract and retain the most talented employees. In their prognosis, they combined a number of societal and business developments that still exist today: an increase in the demand for high-qualified employees to perform increasingly difficult tasks and a shrinking workforce due to an aging population. As a result, they reasoned that only those organizations that succeed in hiring and retaining talents, would have the power to achieve their organizational goals (Chambers et al., 1998). Although the report was criticized because it did not specify what talent means or how to measure it, it resonated with the experience of many executives that it is difficult to trace and attract employees with rare skills and knowledge for crucial jobs in many parts of organizations. There is a shortage of skilled employees in technical professions, nursing professions, and in jobs that people generally disapprove of, for example, working in the meat industry. The War for Talent happens on all levels; it is not only a struggle for star employees at the top of organizations, but this problem of labor market scarcity affects all levels and all organizations. Even countries face problems when there is insufficient labor supply to do all the jobs. Japan, for example, has been suffering from a long-term recession due to an aging population and strict immigration policies (Ducanes & Abella, 2008).

This chapter takes the broad view that the War for Talent is about attracting and retaining employees who are qualified and productive, who are needed to run productive and profitable organizational processes, and who possess skills and knowledge that are scarce in the labor market. The War for Talent is a problem involving macro, meso and micro-level dynamics.

At a macro level, the War for Talent is about the balance between demand and supply in labor markets. This is the research domain of labor economics. Labor economists use workforce and gross production numbers to predict wages, and vice versa to predict how wages affect labor supply and demand. This chapter will touch upon Classical and Neoclassical wage theory without going into too much depth, mostly to familiarize you with the economic concepts used in researching labor markets.

The next level to consider is the meso or organizational level, which deals with managerial strategies to attract and retain talent. Strategic choices at this level involve wage levels and make-or-buy decisions. Efficiency wage theory, which predicts the benefits of paying above market-level wages and argues why it is profitable for organizations to pursue this strategy. The make-or-buy decision involves a calculation of costs and benefits associated with raising homegrown talent within organizations versus hiring employees with ready-to-use talents directly from the external labor market. The flexible firm, an organization where part of the workforce is hired from another employer, such as a temporary work agency (see chapter on Managing Change), is an example of a ‘buy’ decision. Instead of having all employees contracted and managed by the organization itself, flexible firms outsource the employee administration of some groups. This provides the flexibility to ‘buy’ additional labor or downscale quickly as needed. In this chapter, we introduce the internal labor market as its counterpart that promotes a ‘make’ decision in which sufficient qualified staff is developed in-house. Economists point to Transaction cost theory to explain which strategy is most profitable in a given situation. Efficiency wage and transaction cost theory are economic theories, which tend to emphasize the context of behavior (for example rewards, information and budgets).

The micro level in the War for Talent is the domain of psychological theories. It considers within-person preferences, thoughts and mental processes to explain behavior. Ultimately, individuals decide for themselves whether or not to apply for a job, accept a job offer, and like it so much that they choose to stay. Classic psychological theories to predict such behaviors are Equity and Expectancy theory. Equity theory concerns fairness evaluations about the processes and distribution of rewards in organizations. Fairness violations have negative effects on how people feel about their employer and can lead to them quitting. Expectancy theory relates to differences between employees in how they value rewards, and how that in turn affects their behavior. Recently, Psychological contract theory highlighted that many equity and reward expectations remain unspoken between employees and employers, which even further increases the risk of disappointing talented employees. The central question in this chapter is how human resource management can support organizations in attracting and retaining talent in times of labor market shortages, in order to be able to meet the goals of the organization. Before setting out to explain the theories and their practical implications in more detail, the next section starts by defining some of the key concepts in the War for Talent literature.

# Theory

## Key concepts

Organizations need employees to perform the tasks involved in reaching their strategic goals. In turn, employees look for organizations where they can use their skills in return for benefits. The core of employment relations is the dance between employers and employees to find the right balance between organizational and individual needs. The first step is initiating contact, in which employers and employees reach out to each other and explore the possibilities for teaming up. This is the attraction phase. Then, the dance takes off to the retention phase, when both partners continuously balance their needs and demands to determine if they desire to continue their relationship.

Employee attraction is the entire process before an employee engages in an employment relation. Attraction initiated by employers refers to recruitment. This is a very broad domain of activities ranging from employers’ actions to bring jobs to the attention in the labor market, to motivating potential recruits to apply, to offering attractive terms and conditions, and to guarding that a job offer is accepted (Breaugh, 2008). Employees are active agents who can also initiate contact to potential employers in their job search.

After a job offer has been accepted, the employment relationship commences. Retention is the prevention of voluntary turnover, which happens when an employee who is still valued in a job decides to quit. Because undesirable turnover is expensive, considering the loss of productivity and tacit knowledge and additional costs for recruitment and training, employers seek for human resource management strategies to retain valued employees (Holtom et al., 2018; Hom et al., 2017). Involuntary turnover is initiated by the employer or by legislation and happens for example when a temporary employment contract expires, in redundancies, or at the legal pension age. The abundance of research on voluntary employee turnover indicates that a combination of situational and personal factors precedes actual turnover, such as the presence of attractive alternative jobs (pull factors), or a dislike of the current job (push factors) (Griffeth et al., 2000).

The balance between attraction and retention takes place in the context of labor markets, where labor surplus and shortage determine the relative bargaining power during the attraction phase and the relative value of the employment conditions during the retention phase. A labor market is a virtual place where workers and employers interact with each other. Employers compete with each other to hire the best employees, and workers compete with each other for the most rewarding jobs. The number of job openings at organizations determines the demand side of the labor market. The number of employees looking for jobs determines the supply side. Supply and demand of labor continuously change and fluctuate. There are periods of labor shortage, when there are many job openings but few employees suitable to fill these positions, and periods of labor surplus, when there are many workers looking for jobs but only few job openings exist. In periods of labor surplus, many workers find themselves unemployed. Labor shortage on the other hand can be threatening to organizations because it may impede the potential of organizations to get all the work done.

Labor shortage is the proportion of job openings relative to the size of the labor force population. This results in a score that indicates how hard it is for organizations to find employees. Low unemployment rates of less than 5 percent also indicate labor shortage. Variations in labor shortage exist between countries, between industries and between different categories of jobs. The fluctuations between labor shortage and labor surplus have many causes, some of which are temporary and some of which are structural.

Temporary shortage is due to foreseeable changes in the economy. In times of economic growth, the demand for labor is higher compared to when an economy is facing a recession. Labor shortages and surpluses fluctuate with the state of the economy. There are also fluctuations within each year due to the seasonality of some industries, like in tourism or in agriculture.

Structural shortage happens when there are too few workers for all the jobs, regardless of the economic situation. This is problematic for economic growth. Japan, for example, as the third-largest economy in the world after the United States and China, has been facing structural labor shortages for decades, largely due to an aging population resulting in insufficient productive people to fill all the vacancies. This is the result of quantitative shortage: a lack of a sufficient number of workers. However, structural shortage can also result from qualitative shortage. This happens due to a mixture of mismatches. A known qualitative mismatch happens on the demand side, between the type of labor demanded by employers and the type of skills and education that unemployed workers have. This can happen because jobs and job requirements change, but also because students prefer the ‘wrong’ education. For example, organizations look for professionals with technical skills like engineering or law, but students prefer studying event management. Another qualitative mismatch lies in the changing expectations of new generations about work. Younger generations are less likely to sacrifice their personal life for an organization and expect employers to provide them with, for example, flexible work possibilities. If employers do not adapt jobs to these expectations, they will face shortages due to a mismatch on the supply side, because potential employees do not like their jobs. Particularly in times of labor shortage, workers have the bargaining power to demand jobs that meet their expectations.

The debate on structural shortages caused by an aging workforce and changing employee expectations has raised employers’ interests in attracting and retaining talent to their organizations. Human capital theory predicts that organizations with the best employees will ‘beat’ their competitors. In the context of labor shortages, it becomes even more important to find and keep these talents. The word talent, however, has many meanings. It can refer to giftedness, to specific competencies in which one excels, to abilities and skills that predict good performance, to the potential to learn and become a good performer, or to high performance itself (Meyers et al., 2013). The McKinsey report used a relatively narrow definition of talent by only looking at the top performers in the highest ranks of organizations (Chambers et al., 1998). Labor shortages in technical sectors, in health care and education, however, indicate a lack of good performers across a wide range of job levels. In this chapter, the definition of talent therefore includes all employees who possess qualities (education, skills, and experience) for which there is a labor shortage.

## Economic theories of attraction and retention

Economic theories of attraction and retention explore how situational conditions lead to a match between employers and employees. Examples of situational conditions are wages and information, which can be used by employers to motivate employees to associate with and stay in a job. Wages are the overall package of base pay, incentives, bonuses, benefits, and insurances. Although there are theories that predict that various wage components have different effects on employee motivation (Gerhart & Rynes, 2003), the theories selected for this chapter mostly focus on the overall effect of wages.

### (Neo)Classical wage theory

The first economic theory views wages as the key mechanism that determines the balance between labor supply and demand. Classical economic theory finds its roots in Adam (Smith, 1937)’s philosophy about the benefits of the free market for the wealth of people and nations. Just before the industrial revolution, trade was envisioned as a game where making a deal always involved a winner and a loser. Adam Smith proposed that trade did not necessarily need to be a win-and-lose game, but that under certain conditions buyers and sellers could both win. These conditions depend on the demand and supply of the good involved in the transaction. As long as the buyer knows he paid a fair price compared to the number of other buyers interested in the good, and the seller knows that the price is fair given the level of demand for the good, both parties will be happy with the deal. When there is a balance between the availability of the good (the supply) and the need for the good (the demand), the price would be at such a level that it satisfies both buyers and sellers.

In free markets, the need for labor derives from the demand for goods. The demand for labor increases in line with the increase in the demand for a good and vice versa. The motivation to work will increase when individuals see that putting hours in to work leads to more income, resulting in increased well-being. When the demand for a product increases, the demand for labor increases. To attract employees, employers will increase wages, which will result in an increased supply of labor.

The demand for labor also depends on the productivity of workers. In theory, workers should be paid according to their productivity. Workers with more knowledge and skills (such as IT engineers) are more productive than less skilled workers (such as cleaners). For each product sold, knowledge workers add more value to the product than less skilled workers. Differences in the added value of the productivity of workers justify wage differences. Since knowledge workers (the IT engineers) add more value to each product sold, they can demand higher wages. So, in sum and according to classical labor theory, wages are determined by supply and demand factors and workers who add more value to each product sold should be paid a higher wage. Organizations maximize their profit if the added value of each additional worker equals the additional costs of employing them.

This system in which wages are determined by the supply and demand in the labor market functions best when the market is a real free market; that is a completely competitive labor market. Conditions for the existence of such markets are:

1. There are many organizations with identical jobs so workers can compare and choose the best wages.

2. There are many workers who all have the same skills and who are perfectly mobile in switching between jobs.

3. Both workers and employers have all the information about wages and jobs to make rational decisions about wages levels and job acceptance.

In such markets, employers are wage takers. This means that their wage policy is completely determined by the market. Should employers pay lower wages than the competition, workers would not want to work for them. Should they pay higher wages, their production costs would outweigh the benefits. So according to Classical wage theory, there is not much employers can do to use wages as a strategic instrument to attract talent. At least, not any different than any other firm in the market, which in return means they cannot achieve a competitive advantage through their wage policy.

However, it is clear that these conditions are unlikely to exist in the real labor market. In reality, a number of causes obstruct the ideal-type free market and lead to frictions or imperfect labor markets. Frictions describe labor market situations whereby workers are not assigned efficiently to jobs and organizations. For example, think about the following situations:

1. Imperfect labor supply: In reality, not all workers have identical skills or interests in taking and performing any job in demand. To be able to perform skilled jobs, workers often require qualifications. These qualifications may require a lot of effort to obtain, so not all workers are willing to get these qualifications and the number of workers that does have the qualifications is limited as a consequence. Similarly, some jobs are disliked by many workers because they involve heavy, dirty, repetitive or otherwise unpleasant work. This implies that wages need to increase more than would be predicted according to the demand-supply function to motivate workers to obtain the qualifications or to overcome their dislike for unpleasant work.

2. Information asymmetry. By no means do employers and employees know exactly what is happening in the labor market. Employers do not know how employees perform exactly, so they have to use proxy measures to get an idea of workers’ performance levels, such as the degree of education. They also have imperfect information about the offers of other employers for similar jobs. Moreover, employees cannot compare offers of all available jobs, nor do they know exactly what the compensation of each job entails. In cases where one party (employers or employees) knows more than the other, information asymmetry arises, and wage levels can be established below or above the value predicted by classical wage theory.

3. Labor is not perfectly mobile. Moving from one job to another always involves costs for workers, which in return can restrict their mobility. They may need additional training to gain the skills required in another company, or relocation costs occur while moving to another area. Moreover, systematic obstacles like educational opportunities or local laws restrict workers’ mobility. An additional aspect to consider, regarding how wages influence employees’ decisions to move from one job to another, is that wages are not the only aspect that workers look for when accepting a job, nonpecuniary aspects like colleagues and work content play an immense role. These different aspects lead to employees not freely hopping from one job to another. In return, employers are not only wage takers who are dependent on the market but do have some power to influence the wages they pay to their employees.

4. Monopsony power. Some employers have the power to set wages in a certain region because they are the only employer and workers have limited options to decline the wage offer this organization makes. For example, in a town with high unemployment and one dominant employer who hires almost every adult working in that town, this employer has the monopsony power to set wages at a lower level compared to the national labor market. At the labor supply side, trade unions can drive wages upwards in a similar vein, because they speak for a large group of workers who give them power to set wages. Minimum wages are an example of labor-driven monopsony power.

Due to these kinds of frictions, the labor market does not follow a perfectly competitive and ‘classic’ demand-supply model. Neoclassical wage theory has finetuned classical theory to allow for the existence of frictions and imperfect labor markets but is still working from the basic assumptions of classic labor market theory.

For example, instead of assuming full rationality, neoclassical wage theory assumes bounded rationality: individuals take rational decisions based on the information that is at their disposal. Because this information may be incomplete, it may result in suboptimal decisions. The theory is mostly used in macroeconomics. Apart from a better understanding of wages under different labor market conditions, it may hold little practical relevance for organizational strategies in the War for Talent. Efficiency wage theory and Transaction costs (make-or-buy) theory are two mesolevel theories that are more practically relevant for strategic choice.

### Efficiency wage theory

Nobel Prize-winning economist Joseph Stiglitz and his colleague Carl Shapiro at MIT started their Efficiency wage theory by wondering why there is always unemployment, even in high conjunctures when everyone who wants to work can work. Rather than looking at aggregate frictions in the labor market, they concentrated on the economic behavior of organizations and employees and the limited information that employers have about how employees perform to explain how employers decide which wages to pay. They reasoned that it can pay off for employers to pay more than the equilibrium wage as predicted by (Neo) classical wage theory because frictions in the labor market also have benefits for the performance of organizations (Shapiro & Stiglitz, 1984).

The starting point of the theory is that it is impossible, or at least nearly impossible for employers to understand the true worth of each employee’s performance. Employers therefore lack information about the real value of employees. On the other hand, employees can choose the amount of effort they put into their jobs. Understandably, employers look for mechanisms that can make employees put in more rather than less effort to their jobs. One mechanism to motivate employees to work harder, is to increase the threat of unemployment for employees. According to (Neo)classical wage theory, unemployment is the result of frictions in the labor market. Employers cause frictions by paying higher wages than equilibrium level. (Neo)classical wage theory predicts that paying more than the market equilibrium would make organizations unprofitable. However, Stieglitz and Shapiro reasoned that there is profit in higher wages because the higher costs of the salaries pay for themselves in better performance of employees. There are a number of economic reasons why paying high salaries leads to better organizational performance. The most important reason in Efficiency wage theory is that high wages reduce employee shirking.

Shirking is economic behavior. As profit maximizes, employees seek to get the highest rewards for the least possible effort. When employees receive an average pay at the wage equilibrium level, they will do just enough to show their worth at that average level. In other words, at average pay, employees will put average effort into their jobs. However, when employers increase wage, the wage equilibrium gets disturbed and cause unemployment. Therefore, employees will fear that their average effort will not protect them from redundancy. Hence, to avoid unemployment, employees will increase their effort. When employers pay higher wages, they increase the norm for shirking. This leads to better performance of employees.

There are additional benefits to paying above-average wages when it comes to the attraction and retention of employees. Efficiency wages lead to a selection advantage (Stiglitz, 1976). Organizations that pay higher wages attract more workers willing to work for them. By enlarging the pool of applicants, employers can select the most talented employees. Hiring talent is an investment in the human capital of organizations, an important resource for better performing organizations.

Another benefit of higher wages is that employers create a retention advantage (Stiglitz, 1976). Employees in higher-paying organizations do not want to lose their well-paid jobs and will not easily move to another employer. This results in low employee turnover levels. At low turnover levels, employers have to spend less on hiring costs and do not have to invest in training new employees.

A final benefit that Stiglitz and Shapiro included in Efficiency wage theory is gift exchange motivation (Akerlof, 1982). Gift-exchange builds on Social Exchange theory but stated in an economic rather than psychological manner. Employees who receive higher wages than they would earn in similar positions elsewhere feel obliged to return this gift by showing extra effort.

These four mechanisms together (reduced shirking behavior, selection advantage, retention advantage and gift-exchange motivation) explain why above-average salaries motivate employees to perform better. The Efficiency wage theory shows that salaries are an instrument for human resource management to use strategically in attracting and retaining talent.

### Internal labor markets (ILM) and transaction costs considerations

(Neo)classical and Efficiency wage theories explain the role of wages in the external labor market to attract, retain and motivate qualified employees. Both theories focus on differences between organizations in the labor market in determining wages to ‘buy’ and keep talent. The third and final economic perspective presented here are internal labor market theories and transaction cost theory, which both focus on the costs and benefits of in-house talent development instead of buying it on the labor market.

In the period between World War two and the late nineteen-eighties, most employees spent their entire career at the same organization, slowly moving from one position to another. Apart from starter jobs, the external labor market had little relevance for those aspiring career growth. Most employees joined organizations at a young age and grew during their careers through the organizational ranks. Career development was stimulated by the organization, often by providing company specific trainings to employees (Dulebohn & Werling, 2007). This phenomenon relates to the existence of internal labor markets, which involves all job openings in an organization on the one hand, and the entire workforce of the organization as potential applicants on the other hand (Doeringer & Piore, 1985).

Internal labor markets bring cost benefits for organizations. Similar to Efficiency wage theory, they lead to lower costs for external recruitment and training expenses for new hires (Wachter & Wright, 1990). Promoting employees from within the organization to fill job openings saves expensive advertising campaigns and recruiter fees. Moreover, employees in an internal labor market career often do not know the value of their company-specific skills and lack knowledge of the external labor market. Because they fear being unable to find a similar level job outside the organization, and risk losing their current benefits, they prefer to stay with the same employer. By having loyal employees, organizations enjoy reduced recruitment costs. Another benefit is that internal labor markets bring a productivity advantage. Because promoted employees already know the organization, their onboarding program to the job can focus on the technicalities of the new position. Their training can be tailored to the organization, which results in company-specific knowledge for employees. Such knowledge is of high value in the current organization, but due to transfer difficulties is of less use in other organizations. Finally, internal recruits need no introduction to the social network of the organization, and because they are well aware of tacit internal processes, their time to adapt to the new job will be relatively short. This results in internal hires having higher productivity levels at the start of a new job than external hires.

In contrast to Efficiency wage theory, internal labor markets tend to have a lowering effect on wages. This can be explained by understanding typical career patterns in organizations with a traditional internal labor market. The entrance to a traditional career starts right after finishing education, when the employee does not have bargaining power yet. The salary can therefore be set at - or even below - the market equilibrium for a starting position. By just working and staying loyal to the organization, employees see their salaries increase gradually, year by year, because salary growth is mostly linked to years of experience in a job. The promise of career growth within the organization is another incentive for loyalty, since upward career steps for loyal employees relate to a significant growth in salary. Salaries in ILMs are therefore less a function of the labor market, but more a function of employee loyalty and the relative merit of each employee within the organization.

Economics refer to the tempering effect of internal labor markets on labor costs as reducing transaction costs (Williamson, 1979). These are costs associated with developing or managing goods or services in an organization, as compared to costs associated with buying it ‘ready-to-use’ on the market. Doing something yourself minimizes transaction costs but making something you buy fit your needs incurs additional costs. For external hires, these costs will be hiring expenses, contract expenses in terms of negotiated salaries and benefits, and costs for monitoring and training. External hires, since they are not homegrown, need more management control: their contracts should specify what they do and what reward they do it for, and managers need to watch more carefully if the new recruit’s behavior is in line with all the tacit processes in the organization. If you hire someone from outside the organization, you will need to be keener on monitoring this newcomer in the organization. For internal hires, the transaction costs are minimal: they are loyal and already understand all the implicit processes of the organization. Compared to external hires, internal hires require lower transaction costs. Since organizations with internal labor markets invest in developing talent from within the organization, they have lower transaction costs than organizations with an external recruitment strategy.

Despite these benefits of internal labor markets, there are risks as well. For example, loyal, long-term employees often enjoy protection against dismissal. In times of economic turmoil, such a loyal workforce can become a burden to organizations because it hinders organizational flexibility in employment quantity. To balance the benefits of internal labor markets with the need to adjust staffing levels, many organizations nowadays adopt a strategy in which a part of their workforce enjoys the benefits of an internal labor market, supplemented with a flexible pool of employees that do not enjoy these rights (Atkinson, 1984; Lepak & Snell, 2002). This again is a matter of transaction cost considerations: keeping employees strategically in an internal labor market minimizes costs for attracting and retaining talent that is difficult to buy, while easy-to-replace employees need minimal investment, which provides more flexibility and lower costs for this group.

Since salary systems in internal labor markets are designed to foster retention among employees, it is important that their design takes internal comparisons between employees and jobs into account. These include the complexity and responsibilities of a job, rather than the market price for identical jobs in the labor market. Decisions about what constitutes fair pay for a job can be determined using job evaluation analyses (Gerhart & Rynes, 2003). The next section of this chapter turns to psychological theories to understand how employees look at fair rewards.

## Psychological theories of attraction and retention

Where the economic theories in the previous section focus on mechanisms that employers can influence directly (salaries, information), psychological theories look for explaining employee behavior at their mental evaluations of the world around them. Three mental processes deserve attention in explaining if a talented individual wants to join an organization and stay there. The first process is fairness, the judgmental process in which employees determine if their rewards are in balance with their efforts at work. Equity and justice theories explain how employees weigh and evaluate if their rewards are fair. The next process is individual evaluations by employees about the worth of the reward. As the McKinsey ‘War for Talent’ report shows, talented individuals differ in how they value the type of rewards that organizations have to offer (Chambers et al., 1998). Expectancy theory shows how different rewards are motivating for different employees. Finally, much can go wrong in attracting and retaining employees because of misunderstandings between what employees and employers expect from each other. Psychological contract theory explains how this works and what employers can do to prevent the negative consequences of unmet expectations.

### Fairness: Equity and justice theories

Organizational justice theory extended on Adam’s equity theory. Initially, research concentrated on equity in outcomes, but this research was unable to explain why employees sometimes judges inequity in outcomes as fair. This led Thibaut and Walker (1975) and Leventhal (1980) to explore the process that leads to the outcome as an additional condition for fairness. Later, Bies noted that procedures and outcomes are more acceptable if these are communicated by a trustful party, with consideration and interpersonal sensitivity (Bies & Shapiro, 1987). These additions lead to the distinction of three organizational justice conditions for fairness: distributive or outcome justice, procedural justice and interpersonal justice.

Distributive justice is the evaluation whether the distribution of outcome is fair. Examples are the distribution of wages, selection decisions, or the funding of training to employees. For judging an outcome as fair, employees compare what they get to standards. These can be performance norms by the organization, or so-called reference-others: other people with whom an employee compares themselves whether their outcome is justified, given their own and the other’s performance. Distribution justice is about equity, which is the proportionality of efforts in relation to outcomes as compared to some standard or comparable other person (Adams, 1965).

Procedural justice means that the processes and policies that lead to decisions are fair. Individuals may accept the distribution of outcomes as disadvantageous to themselves, as long as they believe that the process leading to this decision is fair. Employees feel treated unfairly when they, or one of their colleagues or superiors, would have received a more favorable outcome if a fairer procedure was used.

Examples are annual employee performance reviews. As long as the criteria for the performance evaluation are clear, and the information used to measure the performance against these criteria differences in the distribution of average, good or outstanding performance are judged as fair. However, if employees see that a colleagues received a better evaluation, seemingly because of being closer with their supervisor, employees will judge this as unfair (Leventhal, 1980; Thibaut & Walker, 1975).

Interactional justice is the fairness of treatment in interaction with others, which happens when the person who uses the procedures and decides upon outcomes does so with sensitivity for the needs and well-being of the employee. An important source for interactional justice are supervisors. A good-quality employee-supervisor relationship makes it easier to accept unfavorable decisions, because the employee will still feel appreciated as a valuable member of the team (Bies & Shapiro, 1987). Some literature distinguishes between warmth and trustworthiness in the interaction. Warmth is the sensitivity towards the employee. Trustworthiness is the employee’s belief that the decision-maker used the right information to make an unfavorable decision. This is sometimes called informational justice (Colquitt, 2012).

To conclude, a positive evaluation of these organizational justice dimensions will lead to a favorable evaluation of fairness. As long as there is organizational justice in the eyes of employees, they will be satisfied with their jobs. The perception of unfairness, on the other hand, is among the main reasons why employees quit their jobs. Hence, ensuring organizational justice is important for retaining talented employees.

### The value of rewards: Expectancy theory

Justice theories do not specify which outcomes matter to which employees. It is somewhat implicit in justice theories that employees who notice unfairness appreciate the outcome at stake. However, individuals differ in how they appreciate various outcomes. The authors of the McKinsey ‘War for Talent’ report interviewed 200 talented individuals at 77 top organizations in various industries, looking into why they work where they do. In addition, they conducted a survey among 5,679 respondents who represent the senior ranks in these organizations (Chambers et al., 1998). The reasons mentioned by talented individuals why they work where they do, prove to be diverse. High compensation and bonuses mattered but mentioned less frequently than the attractiveness of the business (exiting challenges, a great company culture, a good management) and having a cool job (with freedom and autonomy, relevance, and the possibility to advance and develop). The report refers to a talent management strategy, where organizations understand what employees value, and adjust their recruitment, retention and development strategies for talented individuals accordingly. Expectancy theory deals with the question how individual differences in reward appreciation matter with regard to their preferences for certain jobs and organizations and to their intention to apply. The central tenet of the theory is that the degree to which employees appreciate an outcome has consequences for their willingness to engage in a job.

Victor Vroom, professor in psychology at Yale business school, proposed his Expectancy theory in 1964 as a theory to explain employee motivation. He reasoned that the degree of effort individuals put into a task, depends on the extent to which they expect to gain a reward that is of value to them (Vroom, 1964). According to his theory, the motivational path consists of three conditions that influence each other in a multiplicative way. This can be summarized in an elegant formula: Motivation (Performance) = Valence x Instrumentality x Expectance.

The motivation to perform is the amount of effort a person shows. Effort can be shown by behavior, by the intensity and duration put in-, and by extra role performance. In addition, effort can be shown by intentions to apply for a job or look for another job, by preferences about how much employees like to work in a certain job or organization, and by choices like accepting or declining a job offer (Van Eerde & Thierry, 1996). Especially the potential of the theory to predict intentions and preferences makes the theory relevant for understanding how to attract and retain talent. Below, the theory is illustrated with an example about a student’s choice to apply to an educational program after high school.

Valence indicates how much a person appreciates an outcome. It is not the real value, but the anticipated satisfaction one will enjoy after the outcome is obtained. The more attractive, important or desired an outcome is, the larger its motivational potential. Valance works in two directions, if one dislikes a particular outcome, or thinks that an outcome leaves one worse off, the valence will be demotivating. In choosing a profession, for example, a high school student may appreciate working in a hospital and taking care of patients. The profession of a nurse holds potential valence for this student. However, working night shifts scares the student off. The student’s valance of a nursing job consists of his total appreciation of all positive and negative aspects of the job. The more positive elements he or she sees, the stronger the student’s valence for a nursing career.

Instrumentality is the perception about the probability that good performance will lead to the desired outcome. For example, the student understands he or she needs to have the right educational qualifications to be accepted at a school to study nursing. If the student has the right diploma, it is certain that he or she is accepted. However, if the student has a different diploma, or no diploma, the probability of being accepted at a school is reduced. In some prestigious schools, there is fierce competition between the best students for admission. In such a situation, the instrumentality between good performance and receiving the valued outcome decreases. This will reduce the motivation to apply to the program.

Finally, expectancy is the belief that one is able to achieve the required performance to produce the desired outcome. If the admission requirement for a preferred school (valence) is to hold a high school diploma of a given level (instrumentality), the question becomes if the student expects that he or she is able to succeed in obtaining the right diploma. If so, the student has a high expectancy that he or she is able to meet the performance requirements. If this is not the case, the student will reconsider putting effort into applying for the school.

The theory reveals all kinds of risks for organizations in which employees and job candidates do not see valence, instrumentality, or expectancy in things that the organization offers or does. For example, employees differ in the outcomes they appreciate. According to the theory, managers need to understand what (potential) employees appreciate, in order to be able to motivate them (valence). Moreover, it is often unclear what the precise performance requirements are for a desired outcome, for example a promotion (instrumentality). A particularly problematic situation occurs when employees expect that putting all their energy and passion into their jobs will bring them their aspired outcome, but their performance efforts go unnoticed by their superiors (expectancy). Such a lack of due praise is an important source for demotivation.

The expectancy theory has been an influential theory regarding employees’ appreciation of valued outcomes and their expectations about the likelihood of receiving these outcomes. However, research findings for the theory are inconclusive. A meta-analysis conducted on the theory and its extensions, demonstrated that the separate conditions of valence, expectancy and instrumentality each mattered for the predicted outcomes. The most important evidence concerned the prediction of the intention to apply to a job or organization, and the preference for a job, profession or organization. However, there was insufficient research evidence for the $M = V \times I \times E$ formula (Van Eerde & Thierry, 1996). Since each of the conditions in the formula also appear in other influential theories, for example in goal setting theory (Locke & Latham, 2002), self-efficacy theory (Bandura, 1977) and the theory of planned behavior or reasoned action (Ajzen, 1991), the interest in testing the theory waned. Nowadays, you will not find a lot of new research that solely uses this theory. Yet, expectancy theory’s core ideas resonate in psychological contract theory, one of the most cited theories in modern human resource management research.

### Misunderstandings: Psychological contract theory

Expectations influence organizations in many ways. Employees hold expectations about what they ought to do at work and about inducements that their employer promised to provide in return. Some of their expectations are based on explicit promises, written down in a formal job contract. Explicit terms and conditions in job contracts usually concern the contract size and duration, formal working hours, the number of vacation days and the salary that comes with the job. Other promises about obligations and inducements are implicit and will hardly ever appear in a formal contract. Some examples include the promise that a temporary contract will be renewed after good performance, or the expectation that the supervisor will be fair and trustworthy. Other implicit promises are opportunities to learn from colleagues, career opportunities or consideration for personal circumstances. Employers also hold expectations about what employees are supposed to do and how they are supposed to behave. Again, some of these are explicit in writing or verbally agreed, but many remain implicit. For example, an implicit expectation is that employees will put in extra effort in their job when it is busy or help a colleague if necessary. This goes back to even the 1960s when the role of implicit promises about mutual obligations and inducements on organizational behavior was mentioned and referred to as a ‘psychological contract’ that exists in addition to the official written contract. In the 1990s, Denise Rousseau explored the meaning of psychological contracts in more detail in a series of books and studies. Because psychological contracts have not been formally agreed on, there is a risk of misunderstandings, which can have detrimental effects on employee satisfaction. Psychological contract theory is particularly salient in research on talent attraction and retention.

Psychological contracts are defined as an employee’s perception of promises about obligations (what do I have to do) and inducements (what can I expect to get in return) between the employee and the organization. Beliefs about promised obligations and inducements go further than the legal employment contract (Rousseau, 1989). Although some promises are verbally explicated or written down, many are just beliefs, assumptions and interpretations from employees. It is difficult to understand for employers what the psychological contracts of their employees look like, which makes them difficult to manage. Psychological contracts are nevertheless important, because employees may be disappointed because of unmet promises the employer does not even know about. A closer understanding of psychological contracts follows by looking at their content and features, and their development and evaluation processes.

Employees perceive promises about many topics at work. The perceived promised expectations and obligations determine the contents of psychological contracts. These can cover many human resource management practices and organizational behaviors, such as promises and expectations about flexible working possibilities, career development opportunities, interesting tasks or projects, fair pay, equal treatment, how much effort is required, or skills development.

Psychological contracts can vary in their scope, depending on whether their features are transactional or relational (Rousseau, 1990; Rousseau & McLean Parks, 1993). Transactional psychological contracts resemble an economic exchange relationship. A precise task description for a short and fixed period, that is easy to observe and understand from a third-party perspective. Psychological contracts of day laborers, short term subcontracted types of work, or self-employed workers who offer their services to organizations predominantly qualify as transactional. However, because most contracts are more comprehensive than these are, most employment relationships qualify by social rather than economic exchange. In longer-lasting employment contracts, a mutual sense of trust and liking between employees and employers will result in a relational exchange relationship where norms of reciprocity apply (see Social exchange theory in the chapter Investing in People). Social exchange relationships induce implicit promises that develop over time, because the work develops and leads to all kinds of implicit assumptions. Relational psychological contracts contain many implicit promises and obligations, which makes this type of psychological contract prone to mutual misunderstandings.

Figure 1.1 illustrates psychological contract formation, process and evaluation. Psychological contract formation begins long before an employee engages in an employment relationship through processes of social learning (Rousseau, 2001). Societal norms and beliefs, conversations with peers and relatives, and information in the news or on social media all contribute to building a general idea what it would be like to work in a certain profession, industry or organization. The social learning that happens is passive, but a general idea of the obligations and inducements settles in. During the recruitment phase, job seekers actively look for information to confirm their initial psychological contract. Confirming information will make them more eager to pursue a job, while disconfirming information may put them off. In this phase, organizational recruiters can actively send information to try and mold prejudices about working at their organization. In later stages of recruitment, when the contract is negotiated, new promises lead to further expectations. After entry, during the first weeks on the new job, the new recruit starts to actively seek for information about norms for obligations and inducements in the organization. In this phase, the new recruit is eager to learn, and information comes through diverse channels. Any conversation, planned or not, will be used to understand the details of the psychological contract. After a while, the active phase of learning slows down and the psychological contract has largely been shaped. It will still develop and get even more elaborate as work experience builds up.

As may be clear from the development process, the psychological contract is dynamic and changes over time when there is new information that confirms, or disregards perceived promises about obligations and inducements. In case new information confirms the present psychological contract, it will strengthen it.

Confirming information guarantees that the exchange relationship is based on reciprocity. Psychological contract fulfillment leads to positive reciprocal reactions, like job satisfaction, commitment to the organization or the willingness to apply for a job. However, in case of disconfirming information, an employee’s status quo about what they consider their rightful obligations and inducements is challenged. Like in equity and justice theories, a mental evaluation process begins to understand if the changes to the psychological contract are justified. Should the evaluation conclude that the change violates the psychological contract, then the employee will perceive this as a psychological contract breach (Robinson & Rousseau, 1994).

A serious perceived breach of psychological contract happens if employees believe that they met their obligations, but their employer did not reciprocate with the expected inducements. For example, an employee followed a training suggested by the organization to prepare for a more interesting job but is not invited to apply when an open position for that job occurs. Perceived violation of the psychological contract by the employer is a severe event for employees, which evokes negative feelings like anger, frustration and disappointment (Wolfe Morrison & Robinson, 1997). This reaction is similar to what equity and organizational justice theories predict. The only difference is that it now concerns a comparison between the inducements received from the employer and what the employee believed was promised. Since many of the perceived promises in the psychological contract are implicit, contract breach in the eyes of employees can happen without their exchange partner’s awareness. In today’s economy, organizational structures and processes, management and jobs are in a continuous state of transformation, which makes psychological contract breaches more likely to happen.

Psychological contract theory has raised awareness for implicit thoughts that employees have about promised obligations and inducements of their employment relationship. The theory explicates how misunderstandings can have serious effects on the cognitions and behaviors of (potential) employees. Psychological contract theory uses logic and language that also appears in Equity, Organizational justice and Expectancy theory. However, Psychological contract theory adds to these other theories the notion of perceived promises and the risks that comes with these when they are violated in the eyes of employees.

# Key research

Employee attraction and retention have been subject to many studies and multiple meta-analyses. The core topic in attraction is recruitment: all things employers do to have a good-quality pool of applicants for positions in their organization. Voluntary turnover indicates that employees leave their employer at their own initiative, which is an important counter-indicator for employee retention.

1. Recruitment. Two meta-analyses show that characteristics of both the job and organization are important determinants of recruiting outcomes (Chapman et al., 2005; Uggerslev et al., 2012). Second, how the recruitment is conducted has an impact on whether candidates are attracted to an organization or not. Third, personal candidate evaluations of their own preferences in relation to what the organization has to offer was a good predictor of candidate attraction. This indicates that targeted recruitment to candidates is effective, but the costs may be very high. It is comforting to know that, in general, positive communication about the job and organization is effective too.

2. Voluntary turnover. Quite a few meta-analyses have been published that map all types of predictors of voluntary turnover (Cotton & Tuttle, 1986; Griffeth et al., 2000; Jiang et al., 2012; Podsakoff et al., 2007; Rubenstein et al., 2018; Zimmerman & Darnold, 2009). To prevent an exhaustive and potentially repetitive overview of all findings, we only discuss the findings of the meta-analysis by Rubenstein et al. (2018). These authors used machine learning methods to find the most important predictors of voluntary turnover. Machine learning is an analytical technique that seeks patterns in data without feeding the analysis with any theory-based expectations beforehand. If findings of a machine learning analysis confirm the findings of traditional theory-based (regression) analyses, these are robust findings. In line with the previous meta-analyses, the machine learning analysis confirmed a robust effect for withdrawal cognitions (actively thinking about leaving your job) to precede actual voluntary turnover. The findings further confirmed robust results for inducements besides pay, such as training or promotional opportunities, bonuses, and non-financial benefits. In addition, having an interesting and challenging job with sufficient autonomy, good leadership, a positive organizational climate, and organizational support were robust factors in predicting low turnover. Meeting expectations, an aspect of Expectancy and Psychological contract theory, showed varying importance across different types of jobs, organizations and labor markets. This could indicate that meeting expectations is more important when it is easy for employees to find what they expect at another employer, such as a nice boss. The authors conclude that indeed “employees quit bosses, not jobs” (Rubenstein et al., 2018).

Most evidence for the economic theories relevant to attracting and retaining employees exists for the Efficiency wage theory and the Internal labor markets and Transaction cost theory. The (Neo)classical wage theory is used in macro-economic research to predict unemployment and competitiveness levels by econometric modelling of imperfections in the labor market.

1. Efficiency wage theory: Peach & Stanley (2009) confirmed the Efficiency wage hypothesis in a meta-analysis, using 14 causal studies that tested the Efficiency wage hypothesis regarding organizational performance. Indeed, they found that paying higher-than-market wages at time 1 leads to higher than-average profits at time 2 (Peach & Stanley, 2009). In the context of the War for Talent, Fulmer (2009) examined which factors explain the high wage levels for CEOs in a sample of 400 CEOs of US Fortune 500 organizations. After comparing experience, previous performance and responsibilities, she found that retention concerns were the most important driver for CEOs’ high wages. CEOs were offered these high wages because boards feared that their CEO would be ‘raided’ by their competitors. By offering high total pay and stock option plans, they hope to seduce a CEO to stay at the organization (Fulmer, 2009).

2. Internal labor markets as a strategy to retain employees has not received much attention in research since the rise of flexible labor models for organizations. However, a core tenet of internal labor markets is that internal labor markets offer open-ended job security for employees. What recent research does show is that internal labor markets still exist, but for a subgroup of employees that are of strategic value to the organization, or as the outcome of politics and power (more on this in the chapter ‘Power of workers’) (Osterman, 2011; Osterman & Burton, 2006). Employees who are in strategically important positions in the organization enjoy the benefits of an international labor market and show lower quit rates than employees in less strategically important positions. They experience higher job insecurity and show higher turnover rates (Schmidt et al., 2018).

Meta-analyses on psychological perspectives generally support their importance for talent attraction and retention. Fairness theories are the most researched.

1. Fairness: Equity. In the spirit of Equity theory, Williams et al. (2006) performed a meta-analysis to understand what discrepancies between pay level expectations based on self-and-other comparisons in proportion to actual pay levels, meant for employees. They found that discrepancies between expected and real pay leave employees quite dissatisfied with their salaries, which in turn related moderately to withdrawal cognitions (intention to leave) and behavior (absence and voluntary turnover).

2. Fairness: Organizational justice has been central in multiple meta-analyses. Findings show that distributive and procedural justice both have a positive relationship with retention (job satisfaction, commitment) and that they are negatively related to withdrawal cognitions and behaviors (Cohen-Charash & Spector, 2001; Colquitt et al., 2001). In addition, employees’ perception of justice evokes positive emotions, implying that HR systems alone can contribute to realizing positive organizations (Avey et al., 2008; Colquitt, 2012). A critical note follows from a meta-analysis on how cultural differences can temper the reactions to perceived injustice: it was shown that North Americans react more strongly to perceived unfairness than Asians (Li & Cropanzano, 2009).

3. Expectancy theory. The only meta-analysis that examined Expectancy theory in its entirety showed no evidence for the model in its totality (Van Eerde & Thierry, 1996). However, each of the theories’ components (valence, instrumentality and expectancy) related positively to applicant behavior in terms of preferences for a job or organization, the intention to apply and the choice to accept a job offer. The preference for a job (valence) and the belief that one’s qualifications are good enough (instrumentality) have frequently been studied and confirmed in recruitment research (Chapman et al., 2005).

4. Psychological contract theory. Most research on psychological contracts focuses on the effects of contract breach. Zhao et al. (2007) demonstrated that, as expected, breach leads to negative emotions such as withdrawal cognitions and withdrawal behaviors. Contract breach consequences in attitudes and behavior proved to be less severe for older than for younger employees (Bal et al., 2008).

# HR practice

Implications for effective human resource management practices to attract talent to organizations and retain them as long as needed are plenty. Below, we highlight compensation policies, employer branding, employee onboarding and talent management programs.

## Compensation

Employee compensation is the central means in economic theories for attracting and retaining of employees. Compensation is not just the monetary salary, but encompasses the entire package of rewards, which can consist of various elements: a base salary, bonuses, incentive pay, employee stock owner plans, insurances like pension and health care, budgets for training and education expenses, commuting costs, equipment or costs for living expenses. The entire compensation is also called ‘Total reward’ (Gross & Friedman, 2004). Wage theories (Neoclassical and Efficiency wage theory) thus concern this total package. Given the administrative and legal complexity governing compensation, larger organizations often employ compensation specialists. Smaller organizations seek advice from accountants, employer associations or labor broking firms such as temp agencies. Managers often fear the strategic choice for above-market compensation because of the financial costs. However, attractive compensation packages do not need to be expensive, if components are carefully chosen and well-communicated, and if it leads to hiring and retaining (new) talented employees whose performance exceeds the total reward package.

## Employee segmentation and tailoring compensation

The question what makes for a competitive compensation package, in the eyes of employees, is difficult to answer, given that the Expectancy theory states that individuals differ in how they value rewards. Ideally, managers should know the reward preferences of new and current talented individuals. However, this would be a time-consuming and expensive exercise. John Boudreau proposed a marketing approach called employee segmentation to create attractive compensation packages for various groups that populate an organization (Boudreau, 2010). For example, management could hold interviews or questionnaires among employees and ask what type of rewards are important to them and why. By grouping answers, clusters of employees with similar needs and rewards preferences can be distinguished. Management can then use these findings to compose different compensation packages of equal value. Employees can choose the package that suits their personal preferences best. As an alternative, management can use employee input to design a system that allows employees to compose their own compensation package that consists of several elements, up to a maximum. An employee segmentation strategy can further be used to distinguish between groups of employees relative to their strategic value to the organization. This also reduces the overall costs of a compensation strategy. However, managers should be cautious when using this strategy because segmentation that leads to big pay gaps between the highest and lowest paid employees in organizations will reduce the satisfaction of the entire workforce (Bryant & Allen, 2013). A glance at organizational justice theory enlightens the pitfalls of inequity that is perceived as unfair.

## Employer branding

Knowledge of how current employees find valence in working at an organization can be used to develop an employee value proposition for prospective employees. A preview of unique rewards experienced by current employees can be attractive for prospective employees. For example, current employees may find value in the business ambitions, the work-life balance, the hands-on mentality and broad job descriptions. This input can be used to build an employer brand. Employer branding is putting employee valence in the organization to strategic use in communication to prospective employees. It can also be used to strengthen the identity of new and current employees. A strong employer brand can also benefit a business brand. The practice balances between the professional domains of recruitment, communication and marketing in organizations (Edwards, 2009).

## Recruitment

Recruitment are all the activities performed to obtain a pool of qualified applicants to select employees for open positions in organizations. Pools can be sought in the external labor market (external recruitment) or in the organization itself (internal recruitment). Here we concentrate on external recruitment. Communication plays a core role in recruitment, from making potential candidates take note of the organization, by marketing the organization as an attractive employer, and during selection, in negotiating a job offer that recruit like to accept. For an extensive overview of recruitment practice and research, see (Breaugh, 2013).

## Onboarding and socialization

The first days and weeks in a new job are important for socialization and building the psychological contract. During socialization, new employees actively look for information to learn about their new job and work environment. Without proper management, there is a large risk that unrealistic expectations develop. Onboarding includes all activities to prepare new employees to be effective at their jobs and the broader organization. Effective onboarding is more than training employees to make them proficient in their jobs. It also involves the awareness that communication in the first weeks will shape the new recruits’ psychological contracts, which will influence how fair they judge any changes in the organization during their later employment.

Thus, managing expectations is important during onboarding. Interventions to guide expectations are for example, welcoming meetings by senior management, supervisor and colleagues, training days, mentoring, bilateral talks with superiors to set realistic expectations, and regular sessions to facilitate an open conversation about mutual promises and inducements.

## Performance appraisal

Employee performance appraisal is the periodical evaluation of each employee’s performance against a performance standard. Performance goals are set at the beginning of a period, usually for a year but this can vary. Performance appraisals are an important management control device to align employee performance with the strategic goals of the organization. It is a moment to talk about the expected obligations and rewards in the psychological contract. The employees’ superiors and HR usually prepare the appraisal ratings by collecting performance information on all employees. Some employees perform ‘average’, some ‘good’, and a few ‘excellent’. The employees’ direct supervisor communicates the appraisal in an appraisal feedback interview. Even with sophisticated rating procedures that are as transparent and objective as possible, performance appraisal feedback happens in a social context, where employees have psychological contracts and compare themselves to others for fairness. Performance appraisals are prone to employee disappointment and frustration and may lead to withdrawal behaviors if psychological contracts and social comparison processes are not carefully managed (Levy & Williams, 2004). Practical advice on how to prevent social damage while maintaining performance appraisal feedback as a device to align employee behavior with organizational goals includes supervisor training in conducting effective performance feedback interviews and holding regular in-between meetings about performance progress and expectations.

## Talent management

Talent management is another critical HR practice from a justice and psychological contract perspective. Organizations have talent management programs for two reasons. First, it is a planning strategy to ensure that the organization has sufficient qualified human capital in the higher ranks of the organization. The HR practice here is performing workforce analytics to understand the organization’s present employees with regards to the required human capital needed in a coming period. In the War for Talent, Talent management is a tool that is used to attract and retain qualified employees. In the communication, applicants develop expectations about talent development in their psychological contracts. Employees with rare qualities expect that organizations will care about their development. Especially young employees easily switch between employers when they feel that they do not have opportunities for development. These two reasons can lead to different strategies. If talent management is mostly there to ensure that crucial positions have successors, then only a limited group of employees or high potentials qualify for participation in a talent management program. However, many employees who do not qualify as high potentials in the eyes of the organization may experience unfairness and violation of their psychological contracts (Sonnenberg et al., 2014). Inclusive talent management programs acknowledge the risk of losing employees when being restrictive about who is a talented employee. By allowing all employees to apply for development and open all vacant positions to all employees, procedures for promotion become more transparent. This will benefit both the perception of fair processes, as well as contribute to the communication of realistic obligations and promises.

In the 1990s, a War for Talent was predicted in which the success or even survival of businesses had less to do with clever product marketing and organizational processes, but more with the ability of organizations to tie employees with rare skills to their organizations. No organization exists without human capital. Demographic changes and developments in employee expectations lead to a situation in which organizations fight a competitive war over obtaining and retaining the best employees. Attraction and retention under conditions of labor market scarcity have been studied in economic theories addressing macro-dynamics of labor markets, and in work psychology theories looking into considerations made by individual employees.

The chapter highlighted (Neo)Classical wage theory and the Efficiency wage theory as examples of economic theories. Both theories link the demand for labor to scarcity and surplus dynamics in the labor market. Classical wage theory predicts that under conditions of a free market, wages (the price paid for labor) will be at a level where all vacancies are filled and there is no unemployment. In reality, labor is not that mobile. Due to all kinds of frictions, there will be scarcity or a surplus.Neoclassical wage theory includes labor market frictions (e.g., minimum wages) in the prediction of equilibrium wages. More practically relevant for human resource management is Efficiency wage theory, which explains why paying higher wages than competitors in the labor market may lead to more profit. These theories both draw the attention to wages as a means to attract and retain employees.

Internal labor market theory is a meso-level theory about the benefits of developing a labor market within organizations.

Transaction cost theory helps to understand the relative costs and benefits of recruiting employees from within or outside the organization.

On the micro-level, psychological theories explain how employees make sense of what organizations offer them. Evaluation processes explained in fairness theories, Expectancy theory and the psychological contract theory highlights how negative evaluations lead to employees not applying for or leaving their jobs. Organizational fairness theories consider distributive, procedural and interactional fairness perceived by employees. Expectancy theory illustrates how people vary in their preferred rewards by describing conditions of valance, instrumentality and expectancy. Psychological contract theory explicates that fairness may be violated even when employers were not aware that promises were made. It turns the attention to implicit thoughts employees hold about promises and obligations in the employment relation. Together, the theories are relevant for a broad spectrum of HR practices such as compensation, employee segmentation, employer branding, recruitment, onboarding, performance appraisal and talent management.

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