Question

I agree that it is certainly cost-effective for employers to hire from within, for just the reasons you've stated. But why would being promoted within one's own company make an employee want to stay and work for a lower than market salary?

Answer 1

Why being promoted within one's own company would make an employee want to stay and work for a lower than market salary?

Companies that are able to retain talent do not necessarily offer the best salaries. Companies that offer the best salaries do not always exhibit low attrition rates. To understand this it is important to figure out what employees value in a company.

While the compensation is one of the most important factors for an employee, there are other things employees value as well. They are as follows;
1) To be involved and valued: Employees like to be involved in the company business and feel that their contribution matters. They like to take pride in the work they do and feel useful. Higher the involvement higher the loyalty towards a company.
Being promoted within one's own company make employees feel that their contributions are helping the company and their work is being valued. The promotion is seen as increased involvement in the company.

2) Opportunity for growth: When employees see that the company has a career plan in place for them, the tendency to look for opportunities elsewhere goes down. The ultimate aim is to keep progressing and if the current company can do that then risk averse employees would want to stay and grow in the company itself.
Companies that develop leaders and promote employees to fill positions send a message that there is opportunity for growth. It acts as a strong motivator.

3) Respect for Leadership: To employees, the personification of the company is their boss. How an employee sees the company is heavily influenced by the kind of boss she/he reports to. Respecting a leader and wanting to work for the leader is an important factor in employee retention. Employees are more likely to be motivated when their leader is someone who has grown within the organisation. It inspires them to take the same path.
Hence, promotions within the organisation influences the employees promoted as well as those around them.

Thus being promoted within one's own company ticks the 3Cs of Chance, Career and Cause which results in employees wanting to stay and working for a lower than market salary.

Note: Employees are also motivated by other factors like work life balance, job security, quality of peers etc. which are not affected by getting promoted within the company.