Employee referral, social proximity and worker discipline: theory and suggestive evidence from India

We propose a new theory to explain why employers mobilize workplace insiders for the hiring of new staff. In settings with incomplete contracts, we show how workplace insiders can help employers tackle recruit discipline challenges at a lower cost. A key idea is that the employer can use sanctions against the referee to keep the new hire in line. Our model predicts that employers will use existing staff of stature and with accumulated goodwill within the firm as referees, since such staff have a personal stake in their choice of recruit. The model also predicts a strong social tie between the referee and the recruit to ensure that the recruit internalizes the costs to the referee of own misbehavior or underperformance. We use a small, in-depth dataset from India to scrutinize how well the predictions of our theory and of the main rival explanations for referral align with hiring patterns, wage and labor turnover observations. We find suggestive support for our theory and argue that these findings are hard to reconcile with rival referral explanations.