How Do Job Referrals Impact the U.S. Labor Market?

Job referrals help to reduce frictions in the labor market, allowing for greater ease in the matching of workers and firms. What’s more, about one-half of job seekers in the U.S. report that referrals were used at some point during their hiring process.¹ Indeed, firms often encourage their employees to refer job candidates, although some organizations, concerned about nepotism, do not allow employees to refer their relatives.

Given the wide use of referrals, a natural question is: How do referrals affect the hiring process, including the speed with which workers match with firms, the quality of these matches, the wages that the workers earn, and the length of time they stay at their jobs? Benjamin Lester of the Federal Reserve Bank of Philadelphia, David Rivers of the University of Western Ontario, and Giorgio Topa of the Federal Reserve Bank of New York and the Institute of Labor Economics (or IZA) in Bonn, Germany, address these questions and the policy implications in their paper, “The Heterogenous Impact of Referrals on Labor Market Outcomes.”

The theoretical literature has proposed a number of different channels through which job referrals can ease market frictions and affect labor market outcomes. However, the existing empirical literature has struggled to identify which of these channels best explains the patterns observed in the real world, in part because most data sets contain little information about exactly how a worker found their job. Lester, Rivers, and Topa are able to shed light on this topic by making use of a relatively new data set, available thanks to a supplement to the Survey of Consumer Expectations (administered by the Federal Reserve Bank of New York). This monthly survey provides detailed information on how a wide range of U.S. workers — spanning a variety of occupations, industries, demographics, and geographic locations — found their job, including specific information about whether or not they used a referral.

As a first step in their analysis, the authors use the survey data to distinguish the source of a worker’s referral as either a “family member or friend” or a “business contact.”² Further, they classify the skill requirement of each worker’s occupation using the Nam–Powers–Boyd (NPB) occupational index, which ranks job type based on the educational levels and earnings of workers. (For example, legal, computer, and math professions receive the highest NPB scores, while food preparation and building and grounds cleaning/maintenance receive the lowest scores.)

The authors find that both types of referrals — those from business contacts and those from family and friends — are important for helping workers and firms form new matches. However, their analysis reveals that the two types of referrals are used by different types of workers and have very different implications for labor market outcomes. In particular, they find that referrals from business contacts are used relatively more frequently by workers seeking high-skilled jobs, whereas referrals from family and friends are more common in the market for low-skilled jobs.

In addition, they find that workers who find their jobs through a business referral tend to earn higher starting wages but leave their jobs more quickly. Digging deeper, the authors find that these two characteristics are intricately linked: The workers who use business referrals tend to earn high wages because they have frequent job opportunities, which is also why they tend to change jobs often. In contrast, workers who find their jobs through a referral from a family member or friend typically earn a lower starting wage but stay at their jobs for a longer tenure. These referrals act as a “last resort” in cases where workers struggle to find jobs through more traditional channels.³

To further explore the implications of these patterns, the authors construct an economic model of the labor market in which workers use different channels to find jobs, both when unemployed and when employed. Interpreting the data through the lens of an economic model reveals a number of additional insights. Most importantly, since business referrals tend to be used by workers in high-skilled jobs who already have good job prospects through other channels, the use of business referrals tends to exacerbate earnings inequality. In contrast, because referrals from family and friends tend to be used by workers in low-skilled jobs who struggle to find a job through traditional channels, the use of referrals from family and friends tends to reduce earnings inequality. Indeed, the authors estimate that, among low-skilled workers, referrals from family and friends account for over 15 percent of total earnings and a 5-percentage-point reduction in the unemployment rate of low-skilled workers.

These findings hold important lessons for policy going forward. In particular, while nepotism laws are often intended to promote fairness and equality, the authors find that banning referrals from family and friends could hurt the very workers these policies are supposed to protect, that is, workers at the bottom of the income distribution who struggle to find employment opportunities elsewhere. Meanwhile, referrals from business contacts — which are often rewarded at large, private firms — seem to have a greater role in generating inequality.