Firm wage setting and the rise of U.S. income inequality

Rents and the role of firms in wage setting are becoming an increasingly popular area of research and conversation when it comes to income inequality in the United States. Generally, the conversation around income inequality and its causes focused more on the characteristics of workers (such as their level of education) than on the characteristics of the firms at which they work. That’s because in the competitive labor market models that economists tend to favor, firms are not as important as market forces when it comes to setting the wages of workers. In these models, firms don’t have the power to set wages.

Yet a new wave of research shows that perhaps adherence to this model of the labor market might be mistaken. A new paper by economists David Card at the University of California, Berkeley, Ana Rute Cardoso at the Institute for the Study of Labor, Joerg Heining at the Institute of Employment Research, and Patrick Kline at University of California-Berkeley takes a look at the evidence for firms being major contributors to the rise of income inequality. Economists, of course, have known for some time that there’s a large variation in the level of pay across firms. And anyone who’s taken a look at the U.S. economy recently knows that, too. Facebook pays a whole lot more than McDonalds or its many franchisees. But is that because one of those two companies can choose the wages they pay workers or because highly-paid workers end up at one of those two firms?

A similar question arises when we think about the trend over time. Perhaps highly-paid workers are just being “better sorted” to the highly productive, highly profitable firms. To expand upon the example above, are workers better paid at Facebook compared to McDonalds because more highly educated workers are employed at Facebook-like firms or because Facebook pays higher wages than other similar firms.

To get at the answers, economists often account for the structure of a labor market by decomposing each worker’s wage into three “effects”—the human capital effect, the sorting effect, and the pure firm effect. The human capital effect measures the share of wage inequality that can explained by worker characteristics. The pure firm effect is the share that is explained by firm characteristics. And the sorting effect captures how much can be explained by high-paid workers being employed by high-profit firms. Discussions about the role of firms in inequality can sometimes lump these last two effect together. But they are actually quite distinct.

One of the big data trends in economics in recent years that enables economists to better understand the relationships among these three effects is the increased availability of data sets that link records about individual workers with their employers. These data sets (which are much more prevalent in developed economies outside the United States) help economists investigate the role of firms in wage inequality and how much “sorting” of workers can explain changes in income inequality. Work by Card and his coauthors finds a significant role for sorting in the increases in wage inequality in West Germany. In fact, sorting accounts for about of third of the increase in West German wage inequality between 1985 to 2009 while the pure firm (or in this case establishment) effect accounts for about 25 percent of the increase. Preliminary work from a team of researchers looking at the United States also finds a substantial role for sorting in the rise of U.S. wage inequality. In fact, they claim the firm effect is driven entirely by sorting.

How much of the rise in firm-driven inequality is due to sorting or pure firm effects has important implications for the rise of inequality. A role for pure-firm effects would indicate a large role for imperfect competition in our understanding of the labor market. In this regard, the role of rents and firms may be an important trend to consider, but it’s worthwhile to point out that much of the new research is based on data from different countries. And as Card and his authors point out, the role of firms and market power would indicate a need to be aware of the differences in the structures of labor markets. No “theory of everything,” as the authors put it, seems likely to answer the questions here.