This paper presents a theory of labor allocation and of wage-scale formation within hierarchic firms facing a competitive labor market. Our aim is to give an endogenous explanation of the hierarchic differentials in worker quality, wages, and degree of supervision. We also explore the effect of minimum-wage imposition upon such firms and the related problem of interlevel conflicts of interests.

The problem of “internal wage scales” and of internal labor use looks trivial under the neoclassical assumptions that firms are able to make (and costlessly enforce) contracts with their employees in terms of labor services. The solution becomes much less obvious if, instead, we take the more realistic view that the management of human resources within firms involves a “game” between employees who seek to maximize utility and residual owners whose aim is to maximize profits and who resort to incentives and punishments to achieve their goal.