What explains wage inequality across firms? 

David Card, Ana Rute Cardoso, Joerg Heining, and Patrick Kline│ April 14, 2019
Policy brief written with the assistance of Emma Fernandez

Why are wages unequal?

Our work offers a new perspective on the old question: Why do different workers earn different wages? Classical economic modeling largely focuses on differences in wages due to differences in skill levels of workers. Empirical observation, however, reveals great variation in wages across different firms, even for the same worker. We therefore ask: to what extent do wages vary across different employers?

Just as wages vary across workers, there is great variation across firms in their level of productivity, even among firms in the same industry. Firms performing at the top ten percent of productivity are about twice as productive as those in the bottom ten percent of their industry. Firms that are more productive tend to have higher wages as well. Such wage differences could reflect the fact that more or less productive firms tend to hire more or less highly skilled workers, respectively. Therefore, in order to understand the true connection between firm productivity and wages, we review two sets of literature that look at connections between employers and wages: studies of the impact of shocks to productivity on wages, and studies of the movement of workers between firms.

Productivity shocks

The first set of literature we review examines the impacts of shocks to firm productivity on workers’ wages. By examining what happens to wages when a firm becomes more or less productive, we can get a better idea of how productivity and wages are linked. Past studies fall into three main groups. The first group of studies, conducted in the early 1990s, used industry-wide measures of productivity and individual-level or firm-wide average wages. They found that the average wage-productivity elasticity was around 0.16. In other words, wages tend to increase by 16% when employer productivity increases by 100%. The second group of studies, conducted in the mid-1990s, used firm- or establishment-specific measures of productivity and workplace average wages. They found average elasticities of 0.15. More recent studies have used firm-specific measures of productivity and individual wages, and have found lower elasticities, averaging 0.08.

We replicated these studies with new data from Portuguese firms. Initially, we found elasticities in the 0.2-0.3 range. But, when adding controls for the type of industry, the measure of elasticity was reduced by 10-20%. We also found that the responsiveness of wages to firm-specific shocks is smaller than the responsiveness to sector-wide shocks. Overall, we estimate the elasticity of wages with respect to value added per worker to be between 0.05 and 0.10.

Worker movement

The second set of literature we review examines the wages of workers who move between firms. Comparing the wages of the same worker at different firms allows us to be sure that we are not observing self-selection of workers to firms. Reviewing studies of worker movement reveals that wages do change across firms for the same worker. When workers move to higher-paying firms, their wages rise. As we know from the productivity literature, more productive firms pay higher wages; but these firms also hire more productive workers. About 40% of the wage difference between more and less productive firms is based on this sorting by skill level. Overall, the literature indicates that about 20% of the variation in wages observed is due to the effect of specific firms. 

Modeling wage setting

Our literature review and replication showed that wage inequality is impacted by differences in worker skills, but that employer characteristics matter too.  This means that a model of perfect competition between employers, in which no individual employer exerts any influence on the wages paid to a given worker, does not accurately describe wage setting for most workers. We propose a static monopsony model of wage-setting, similar to the models widely used by economists to understand how firms set prices for grocery products, gasoline, automobiles, etc.  We show that such a model provides a clear interpretation of the link between employer productivity and wages. The consideration of imperfect competition in the labor market has important implications for how we view the impacts of labor market policies, such as minimum wages, unemployment insurance, and employment protection.