Why do some of the most prestigious employers on the planet—iconic names like McKinsey, Goldman Sachs, and elite corporate law firms—invest so heavily in recruiting brilliant young talent, training them intensively, and then dismissing many of them just a few years later? At first glance, the practice appears illogical and wasteful. But research published in the American Economic Review argues that this cycle of swift hiring and strategic firing is not only rational but central to how high-status professional industries operate. Two economists from the University of Rochester and the University of Wisconsin–Madison show how reputation, information, and exposure to talent interact in fields where individual skill is easily observable, such as law, consulting, investment management, auditing, and architecture. In these environments, firms act as “intermediaries” that both hire talent and lend them credibility in the eyes of clients who cannot judge skill for themselves at the outset.
Early in a worker’s career, the firm possesses valuable private information about the worker’s ability. It can assess how quickly they learn, how well they perform compared to peers, and how much potential they have. Clients, however, know none of this. As a result, the firm can pay its talented recruits less than they are genuinely worth because those individuals have no reliable way to prove their quality to the outside world. Workers accept this underpayment because remaining at a prestigious firm serves as a strong signal of reputation. Simply surviving at a top institution implies that one belongs to an elite group.
Over time, however, this information advantage diminishes. As employees build a track record—winning cases, managing profitable portfolios, delivering strong project results—clients begin forming their own evaluations of the worker’s talent. The gap between what the firm knows and what outsiders can see narrows. At this point, the firm risks losing its leverage: if clients can now identify who is highly skilled, those employees could demand much higher pay.
To avoid this, the firm initiates what the researchers call “churning”: selectively letting go of capable workers who may be slightly less exceptional than others. Crucially, clients cannot distinguish those who are fired from those who remain—they all appear to be talented alumni of a prestigious employer. In fact, those who are dismissed often benefit from this perception, finding lucrative opportunities elsewhere because their previous affiliation signals high ability.
Meanwhile, the firm gains leverage over those it keeps. It can pressure them into accepting lower pay by threatening dismissal, which would label them as the weakest of the remaining group. The retained workers comply because staying at a top firm continues to build their market credibility.
What looks like a ruthless “up-or-out” system is, in reality, a stable equilibrium. It allows firms to maintain profits, workers to build valuable reputations, and clients to ultimately discover high-quality talent they could not assess on their own. Far from being wasteful, this cycle of selective turnover is a strategic mechanism that refines reputations, identifies excellence, and rewards actual skill in the long run.
More information: Ron Kaniel et al, Intermediated Asymmetric Information, Compensation, and Career Prospects, American Economic Review. DOI: 10.1257/aer.20200169
Journal information: American Economic Review Provided by University of Rochester