Equilibrium unemployment with internal labour markets

The Polo approach to the labour market is based on a clear distinction between trade and production. This paper argues that this separation is not realistic because many firms in developed economies usually fill an important share of their vacancies by upgrading incumbent employees. The implications of the existence of internal labour markets are explored with the help of a simple model that extends the well known Pissarides setup. The main result is that the distribution of unemployment by education is correlated with the relative importance of internal labour markets. In particular, I show that more internalization is associated both with more inequality in the distribution of unemployment (with the burden falling mainly on the less educated) and with less inequality in the distribution of wages by education. The model also generates in a simple way upward-sloping wage profiles, which are offered by firms with internal labour markets to their recruits, who face a nonzero probability of promotion to a skilled job.