Theories Of Inter-industry Wage Differentials

Standard competitive theory suggests that equally productive workers receive compensation schemes that would provide an equal level of utility. The remuneration would depend solely on workers abilities and would not be influenced by the characteristics of an employer. Inability to find relevant empirical evidence to support this theory would facilitate appearance of alternative theories stating that true wage differentials exist across industries, even for identical workers. Such industry wage differentials arise in the models of efficiency wages compensating differences, rent sharing, and in many others. In this article we discuss four basic theories explaining large and persistent wage differentials.

As mentioned above, one explanation of persistent wage differences among observationally similar workers in competitive labor markets rests on differences in workers? productive abilities that are not captured in individual-level data sets. High-ability workers earn higher average wages; industries that employ proportionally more high-ability workers pay higher average wages to observationally equivalent workers. This theory is supported by the empirical findings of Katz (1987), Helwege (1989), and Murphy and Topel (1987, 1990). It is worth noting that this hypothesis does not deviate from standard competitive theory of wage determination, since the reason for higher wages is workers ability that we can not capture in the estimation.

Goux and Maurin?s (1999) findings also support the ?unmeasured abilities? hypothesis. They estimate inter-industry wage differentials using new French longitudinal data that allow them to track workers and their firms over time. The authors find that, when measured on a cross-sectional basis, they primarily reflect the inter-industry variations in unmeasured labor quality. However, through the matched employer-employee data they control for firm-level effects and find that inter-industry wage differentials are only a minor component of inter-firm wage differentials. These findings are much closer to those of Murphy and Topel (1987) than to those of Krueger and Summers (1988) that are discussed further in this chapter.

The second model explaining inter-industry differentials is efficiency wage theory. The theory holds on the assumption that some firms pay higher wage than the going wage for the workers of the type they attract. The rationale for doing so can be either these firms do not profit-maximize, or they find paying higher wages more profitable. The latter alternative is on what efficiency wage theory holds.

According to efficiency wages there are at least four reasons why employers pay wages above going wage levels. Firstly, it is believed that workers are paid in excess to avoid high turnover costs (Salop (1979), Stiglitz (1974) and (1985)). If turnover costs are responsive to wage rate increases, then there may be an incentive to pay higher remuneration. The second possibility is that increasing wages raise employee effort level (Shapiro and Stiglitz (1984)). Workers who are paid only their opportunity cost may have little incentive to perform well, since dismissal from the current job would not be costly. By larger wages employers may simply improve worker performance. The third reason states that workers loyalty to the firm increases with the extent to which the firm shares its profits with them. And lastly, the final reason is about selection: firms that pay high salaries attract a higher quality pool of applicants.

In this respect it is necessary to mention Krueger and Summers (1988), who present estimates of the effects of industry switches on wages through a first-differenced regression on matched May Current Population Survey (CPS) data. After attempting to correct for false industry transitions, Krueger and Summers (1988) estimate that the industry wage differentials from the first-differenced regression are significant, of the same sign, and close in magnitude to the cross-section regression estimates. In this way they reject the competitive wage determination hypothesis and conclude that their empirical finding casts “serious doubt on ‘unmeasured labor quality’ explanations for inter-industry wage differences”. In other words, (after controlling for other observables) workers moving from high- to low-wage industries experience a wage decrease, while those moving from low-to high-wage industries experience a wage increase. Moreover, the size of these wage changes is similar to the difference between the relevant industry wage differentials estimated in a cross-section.

The third model postulates that the finding of stable inter-industry wage differentials could be explained by pointing to compensating differentials. The compensating differentials argument is that agreeable and disagreeable job attributes vary systematically with one?s industry of employment, and therefore necessitate wage differentials to compensate employees for non-wage aspects of the industry. Attempts to find empirical evidence supporting this theory can be found in Brown (1980) and Smith (1979).

The final model of rent sharing is based on the numerous empirical findings stating that profitable firms pay higher wages even when controlling for human capital characteristics and firm fixed effects. In other words, the rent-seeking model predicts a positive correlation between profitability of the firm and the wage rate paid to the employees. Based on this model we would expect that industries with high profit margin would be paying higher wages compared to the industries with lower profit margins. Empirical evidence for this theory can be found in Plasman, Rycx and Tojerow (2006), who utilized the Belgian firm-worker matched data set.