The Risky Hire

Posted by Jeff Carter
on July 26th, 2010

It’s no secret that unemployment is close to 10% now. If you run a business and are hiring or if you are looking for a job here is an interesting way to view it. From a book written by Professor Edward Lazear, Stanford, and Professor Michael Gibbs, University of Chicago, comes a notion of the “risky hire”.

When the word “risky” is used in finance and economics it doesn’t mean going to Vegas and putting it all on red. It does mean that there is more variance in whatever you are describing as risky.

Suppose you ran a business and needed to hire a person. You interviewed two people, Jimmy and Johnny. Both seemed pretty nice. Had a nice suit on, with decent resumes. However, there was a big difference between Jimmy and Johnny. Jimmy had a little experience in your business. In college, he interned at a similar business. On the other hand, Johnny had no experience. But Johnny seemed to have some intangible qualities that you really liked and thought might make him a star person for your business.

Lets assume some numbers to quantify the decision. You aren’t going to hire this person on “gut feel” alone are you?! Assume that Jimmy was going to make you 200k per year. But Johnny is different. There is a 50% chance that he’d make you $500,000 per year. But, there is also a 50% chance that Johnny becomes a 100k a year loser for the business-a lemon.

Here is how the math looks:

Expected output of Jimmy=1×200,000=200,000

Expected output of Johnny=.5(500,000)-.5(100,000)=200,000

But, lets look at something else. How about profits? That’s what businesses are really interested in. Profit looks really different for Johnny and Jimmy. Assume we pay each of them $100,000 per year for up to ten years. Also assume that after the first year, the business will have a really good idea of how productive they will be. If Johnny hits a homer his first year, the business keeps him. If not, the business lets him go. Johnny can start looking for jobs.

Profit for Jimmy=$200,000-$100,000=$100,000×10=$1,000,000. Not bad.

Profit for Johnny=.5x$4,000,000-.5x$200,000=$1,900,000! The business makes 900k more by taking a risk and hiring Johnny! (The business will fire Johnny after one year if he is not working out) This personnel manager looks like a hero!

Hiring Johnny is like a real call option for the business, with a one year expiration. The business gets the upside of it works out-and loses a little if it doesn’t. There is limited downside risk.

Professor Mike Gibbs says, “In what kinds of jobs is this most important? Those where creativity, innovation, new ideas are needed. Where the environment is changing and you need someone to think and develop new approaches to the problem. Where you can assess their fit and talent relatively quickly. And, look for a person with a very interesting track record of success, creativity, possibly even changing fields and taking some risks. Unlike in stock markets, risk is often a good thing in a new employee. Employers out there – take a chance on someone!”

If you are looking for a job, you might want to make it easy on firms to take a chance on you. Offer to structure your pay and benefits with performance based incentives. You produce, everyone wins.

Something to think about when unemployment is close to 10%.

****a similar example is in the book Personnel Economics In Practice that I linked to at the top of this blog.

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