Does product market competition increase wage

inequality?

Maria GuadalupeLondon School of Economics

MIT

Motivation

Increasing competition in product markets: Important deregulation period GlobalizationFall in transport/information costs

Increasing wage dispersion:Returns to skillResidual inequality, returns to unobserved abilityWithin industry inequality

How do changes in product market competition affect the wage structure?

Effect of competition

Traditional explanation of effect of competition: rent sharing and inter-industry wage differentials

This paper: Further link between product and labor markets beyond the “between” argument

Competition will affect: – the structure of wages by sector, second moment of

the distribution– returns to skill within sectors will increase with

competition

Effect of level of competition on wage dispersion

Why might competition affect wage dispersion?

Illustrative model for the dynamics of labor markets when:– product markets are imperfectly competitive– workers are heterogeneous.

Argument: the relative returns to ability/skill increase as product market competition increases, just from the change in market structure.

Intuition: As PMC increases the sensitivity of profits to costs is higher, high ability workers can produce at lower costs. Firms will pay relatively more to high ability workers in competitive product markets (it’s a relative effect)

Other mechanisms are possible.

Wage dispersion and competition

Empirical analysis:

Difficulties: Finding good measures of product market competitionBeing able to exploit within individual variation and

estimate returns to skill from micro data

Strategy: Two quasi-natural experiments: currency appreciation

and European Single Market programExploit long individual panel: complete work histories in

the NES (UK)

Contribution of this paper

I identify a causal effect of increasing product market competition on returns to observed and unobserved skill from:– individual data– exogenous changes in competition– three different measures: different sectors and

periods– independent of union behavior

This mechanism operates within sectors and provides an explanation for increasing returns to skill and ability

I provide a mechanism for why such a link may exist and discuss other alternatives

Outline of the talk

I- Related literature

II- Economic mechanism; Implications of the model

III- Econometric specification, identification strategies and results: III a- Concentration ratiosIII b- Quasi-natural experiment 1:

Exchange rate shockIII c- Quasi-natural experiment 2:

European Single Market Program

IV- Conclusion

I- Related stories (and literature)

• Wage inequality literature (trade, SBTC and institutions)• Inter-industry wage differentials and rent sharing

(Krueger and Summers, 1988; Van Reenen, 1996; Abowd and Lemieux, 1993; Gibbons and Katz; 1992)

• Union bargaining and deregulation (Rose, 1987; Hirsch, 1993 2000; Card, 1996; Fortin and Lemieux, 1997)

• Trade and concentration (Borjas and Ramey, 1995; Revenga, 1992)

• Performance related pay, managerial compensation (Cuñat and Guadalupe, 2003)

• Economics of superstars (Rosen, 1981)

• Interaction between product and labour markets (Blanchard Giavazzi, 2003; Bertrand Kramarz, 2001; Bertrand, 1999)

II- Illustrative economic mechanism

Competition increases returns to skill, illustrative mechanism based on cost-cutting ability of high skill workers:

Intuition: As PMC increases the sensitivity of profits to costs is

higher: defining feature of competition (Boone 2002)High ability workers can produce at lower costsFirms will pay relatively more to high ability workers in

competitive product markets (it’s a relative effect) –relative marginal product changes with competition

Crucial: Workers are heterogeneous and imperfect substitutesImperfect product market competition

Setting

N firms produce in imperfectly competitive product markets θ

Each hires one worker to produce,

Max П (di,θ)=(Pi (θ)-di)Yi (θ) –w(di)П (di; θ) –w(di)

High skill workers can produce at lower costs di Reservation wage b

Solve in two stages

~

Equilibrium wages

Second stage: N firms maximize profits in product markets given the level of competition θ. Earn profit (gross of wages)

П (di,θ)=(Pi-di)Yi П (di; θ) Gross profits increase in the ability of the worker hired.

First stage: Each hires one worker: offer wages to each skill given what they expect to earn with that worker.

Max profits subject to the participation constraint of workers

Profits equalized in equilibrium, defined by П (dN;θ)-b -this defines equilibrium wage schedule

П (dN;θ)-b= П (di;θ)-w(di)

w(di) = П (di;θ)- (П(dN;θ)-b)

~ ~

~ ~

~

~

d

П(d)

bW

Revenues and wages~

П(d)~

dN

Sufficient condition for PMC triggering wage dispersion

The slope of the wage function becomes steeper as competition increases (single crossing)

This is satisfied in a number of competition models:– Dixit-Stiglitz, Cournot with heterogeneous workers– Boone (2002) identifies it as the common property

to a number of models (hotelling model, d-s, cournot to bertrand, cournot): it is what DEFINES an increase in competition

It underlines important features of PMC with heterogeneity

Increase in θ with free entry

d

П(d)

b

dN

П(d) =w(d)~П’(d) =w’(d)~

~

Increase in θ

d

П(d)

П(d)

b

W

W’

П(d)’

dN

~

~

~

Implications

Changes in PMC imply changes in the relative rewards to different abilities: skills

No a priori result on average wages. Wages may increase/decrease for some workers

No a priori results on composition of remaining firms and employment

Difficulty: finding a convincing measure of product market competition/identify the effect from within sector changes

Alternative explanations

Standard explanations for wage inequality: skill biased technical change, trade, institutions

Wage compression by unions changing with competition

Returns to managerial ability or returns to skill

These will be dealt with in the empirical analysis (identification strategy or explicit analysis)

Data

Individual panel: UK New Earnings Survey (1982-1999)

– employer reported wages and hours– 1% UK labour force, random sample – complete work histories, tenure, age, occupation– males, manufacturing sector (500,000 obs on 83,000 ind

103 sectors)– Dep. variable: log real hourly wages excluding overtime– Skill: occupational classif. proxies education, 3 levels

Sectoral measures for competition: – ONS/ARD manufacturing sector (1982-1999): Top 5

concentration ratios by year at 3 digit SIC. Computed on census of manufactures.

– Import penetration by sector from ONS

III a- Relationship between concentration and returns to skillIndividual wage regressions

ln(wijkt)=α+θkCjt+Xijkt’γ+dt+dk+dj+νijkt

νijkt=ηi+dkt+dkj+εijkt

Cjt: Product Market Competition

Coeff. of interest: θk [θk –θk’] returns to skill change with PMC

Xijkt Individual characteristics

III a- Relationship between concentration and returns to skill

ln(wijkt)=α+θkCjt+Xijkt’γ+dt+dk+dj+νijkt

νijkt=ηi+dkt+dkj+εijkt

ηi Individual fixed effects: Identification from variation for same individualAccounts for compositional changes (observed and

unobserved)

k*t: trends by skill (skill biased technical change)

k*j: wage differential varies by sector and correlated with competition (eg. degree of wage compression of unions varies by sector)

Concentration ratios

yr

avtop5w avempxtop5

82 84 86 88 90 92 94 96 98

.16

.18

.2

.22

.24

.26

.28

O revenue ∆ employment

Wage dispersion and concentration

Further analysis

Between sector changes or within sector variation in competition? control for industry specific individual fixed effects

Returns to unobserved skills: quantile regressions

Limitations of the analysis

Concentration as a measure of competition:

Economic critique: Theoretical and empirical (measurement)

Econometric critique:Concentration changes endogenously (Tech Change), correlated with an omitted variable

Quasi-natural experiments: Large shocks to competition that affect some

sectors more than others Plausibly exogenousIdentify a causal effect

III b- Empirical strategy (1): exchange rate fluctuations

UK is a small open economy, exchange rate fluctuations are exogenous/ cannot be forecasted

Large appreciation of the pound in 1996 means that high import penetration sectors suffer a larger increase in competition: quasi-natural experiment

Effective exchange rate: 1996 appreciation

Effective exchange rate (£)

60

65

70

75

80

85

90

95

100

105

110

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Effective exchange rate (£)

1996 appreciation

Prediction: Sectors with high openness will increase relative wages more.

ln(wijkt)=α+θk(post96t *impj) +βk post96t +δk impj +Xijkt’γ+dt + dk + dj+ηi+ εijkt

Post96t : dummy equals 1 after 1996Imports change endogenously with exch. rate changes :

impj average import penetration between 1993 and 1995.

Difference in the changes in returns to skills for sectors with different exposure to increase in competition

Std. Errors clustered by sector

Robustness checks

Source of identification:

Sector movers and stayers

Interpretation of the result:

Trade Unions Control for union density and wage compression

Low unionized sample (<10% in 1994)

III c- Empirical strategy (2): The European Single Market

SMP introduced fully in 1992, designed to bring down internal barriers

Measures: common rules on regulation, standards, takeovers, state assistance to industry, patents, company accounts and disclosure of info., opening up of public procurement to competitive tender and disclosure of information, common competition policy

Considerable reduction in entry barriers: different sectors would suffer differently depending on the degree of non-tariff barriers before 1992

A natural experiment: SMP implies a general increase in competition. The increase will be greater for sectors with high non-tariff barriers before the SMP.

Empirical strategy (2): The European Single Market

Classify manufacturing industries as high/low sensitivity (SENSj) and before/after 92 (post92t) (Mayes and Hart (1994), Griffith (2001))

Test of the experiment: Griffith (2001) estimates changes in the Lerner

index with firm data: it fell 1% more in sensitive sectors Impact on market structure? Concentration fell

by 3.3%more in sensitive sectors

Prediction: returns to skill increase more in sensitive industries post-92

ln(wijkt)=α+θk(post92t*SENSj)+Xijkt’γ+βk post96+δk impj

+dt+dk+dj +ηi+εijkt

Robustness checks SMP

Source of identification:

Sector movers and stayers

Interpretation of the result:

Trade Unions Control for union density and wage compression

Low unionized sample (<10% in 1994)

Returns to unobserved skill: quantile regressions

Contribution to changes in wage dispersion

How much of observed skill gap do these represent?

- Increase in concentration: 0.4% to 2%

- 1996 experiment: 7%

- 1992 SMP: 2.6%

…these three sources of increasing competition represent around 10% increase in the skill gap. There are many other channels through which competition increased where this could have an effect.

IV- Conclusion

Empirical evidence that increased PMC implies higher returns to skill: – Causality– Sizeable effect of the three sources analyzed– Within sectors, although some between– Importance of compositional changes– Returns to unobserved ability– Unions

Relevance of the economic link from product markets to labor markets: direct effect on the structure of compensation

Broader picture

Other effects on compensation structures: Returns to skills vs./ Incentives to effort:

performance related pay and product market competition

Open questions for further research: other implications of the outlined mechanism on organizations– on union bargaining and membership; – implications on other cost-cutting investments:

organizational change and technology