Earnings dynamics and firm-level shocks

Benjamin Friedrich, Lisa Laun, Costas Meghir, Luigi Pistaferri 08 August 2019

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How important is the firm in which a worker is employed in determining that worker's wages? And how much of the wage fluctuation over that individual’s career reflects changes in the productivity of the firm? In other words: does working at a fast-growing firm like Facebook, or a fast-shrinking firm like Motoror matter for how much workers are paid and how much their wages grow over time? These questions are important for understanding the sources of inequality between and within firms, as well as the risks that individuals face over their lifetime.

Labour economists have studied extensively how firm characteristics matter for explaining wage differentials across workers (Oi and Idson 1999, Abowd et al. 1999). But there is much less work addressing the extent to which fluctuations in the firm’s fortunes are passed on in wages, in part because of the formidable data requirements (Guiso et al. 2005 and, more recently, Lamadon 2016, Kline et al. 2019). 

Fluctuations in productivity and wages

Fluctuations in the fortunes of firms may be due to many events. Firms may be affected by product market shocks – a sudden change in exchange rates for exporting firms, an increase in value added tax, a product innovation by a rival firm. Or firms may introduce new technologies or new management styles that make them more productive. Some of these shocks can be structural, or permanent, while others can be more temporary in nature. 

Economic theory states that, in a competitive labour market, wages are not related to firm characteristics: workers bear only the risk of shocks to their own productivity, which they carry with them wherever they work, and they bear them fully. 

But imperfections in both labour and credit markets can create a link between firm performance and the wages of their workers. For example, workers can earn a share of their wages in pay-for-performance schemes, or receive bonuses that are tied to how well the firm is doing (van Reenen 1996). These schemes will naturally induce some sharing of risk between firms and workers. 

The influence of firm-level shocks on wages may also depend on more than match-specific productivity. This is because firm shocks impact all workers at the same time, while match effects are specific to the worker-firm pair. In our recent work we have studied how changes in wages are related to fluctuations in firm-level productivity shocks. Volatility in wages is often interpreted as a measure of economic risk faced by workers. Therefore, our research relates directly to understanding the amount and sources of risk faced by individuals. Our findings also relate to the competitiveness of the labour market, making it an issue of first-order importance from a number of perspectives. 

Taking job mobility into account

Previous work on the subject (e.g. Guiso et al. 2005) has focused on workers who are continuously employed at a given firm, thus ignoring job-to-job mobility and the transitions between employment and unemployment. Such transitions may hide the impact of firm-level shocks on wages, because a worker may quit or switch jobs instead of suffering too large a pay cut when firms perform poorly. The focus on continuing workers may thus understate the role of the firm’s fortunes on wages, since part of the adjustment to firm shocks may come from job-to-job switches or movements in and out of employment.

In our work, we explicitly allow for the endogeneity of transitions between employment and unemployment, as well as between jobs. We use workers’ data drawn from Swedish administrative records and match these records with data on firm balance sheets. The result is the universe of workers and firms, matched to each other between 1997 and 2008. Since we lack information on working hours, we focus on men. To allow for an important source of heterogeneity, we look separately at the experience of individuals with college education, and without it.

In our work there are three sources of stochastic variation in wages that are often confounded, mostly due to imperfect data:

  • Idiosyncratic to the worker. This source is portable between jobs. It varies over time due to transitory and permanent components – for example because of short-lived spells of sickness or long-lasting skill depreciation. 
  • Specific to the worker-firm match. This can potentially also vary over the life of the relationship, due again to short-term or long-term developments such as learning or between-firm competition for talent. 
  • A rent-sharing component. This depends on how much the fortunes of a firm make their way onto the workers’ wages. By its nature, this component induces correlation across wages of similar workers within the firm. As said above, it would be unimportant in settings in which labour markets were perfectly competitive. It would also be absent in settings in which institutional features (such as union contracts) prevent wages from absorbing firm-side fluctuations, while allowing for industry-wide developments to matter. 

We measure firm shocks with unexplained variation in the firm’s value added per worker. We find that firm productivity is volatile, and that this volatility transmits to wages. 

The extent of pass-through depends on the type of shock, and on the type of worker considered:

  • High-skill workers exhibit a larger pass-through, particularly when it relates to shocks that are more permanent, such as the introduction of new firm technologies. Thus the firm is responsible for a high fraction of the cross-sectional volatility of wages attributable to unobserved components, and interpreted as uncertainty. For example, we calculate that by age 55 about 39% of the cross-sectional variance of wages for high-skill workers is attributable to firm-level shocks. 
  • For unskilled workers, temporary shocks to productivity (such as demand fluctuations) transmit to wages, but overall this does not explain a large fraction of the wage variation. For them, only about 5.6% of the cross-sectional variance in earnings can be attributed to the firm by age 55. 

This is potentially consistent with union protection being more important for these workers. Indeed, one way of interpreting the results is that the wages of low-skill workers are close to the minimum wage thresholds set in collective bargaining agreements, reducing the transmission of negative firm-level shocks onto wages. We also find that employment is strongly related to wage shocks, consistent with self-selection into work, and work incentives. Finally, job mobility is highly dependent on wage offers, although other factors lead workers to take wage cuts when they move across workplaces.

Counterfactual scenarios

To better understand the implications of our main findings, we simulate our model in a number of counterfactual scenarios in which we change the nature of wage variability over the life course of a worker.

In one scenario, we eliminate any pass-through of firm shocks onto wages, but continue to allow for the possibility of match effects (the fact that workers may be more productive at some firms than others). In another scenario, we shut down any form of firm influence on wages (both match productivity effects as well as firm shocks pass-through). We find that wage variance over the lifecycle decline substantially when eliminating the impact of firm shocks, less so when match productivity shocks are eliminated (with the effect being particularly relevant for the high-skilled). 

One way of attenuating the impact of firm shocks on earnings is through moves – both between jobs, and between labour market states. To study the importance of this form of selection, in another set of counterfactual experiments we eliminate selection by preventing job-to-job moves or quits into unemployment. If workers cannot move or quit (which are extreme forms of labour market frictions), shocks stay with them longer and cannot be avoided, resulting in higher variances over the life cycle. We show that this is mostly due to pass-through of firm-specific shocks. Hence, worker dynamism (the ability to quit into unemployment, or move to an alternative employer) represents an implicit form of insurance against labour-market risks. This is particularly relevant for recent US experience that shows declining fluidity and dynamism in the labour force (Davis and Haltiwanger 2014). If our results were to extend to the US labour market, they would suggest that, in the future, firm volatility will pay a larger role in wages.

References

Abowd, J M, F Kramarz, and D N Margolis (1999), “High Wage Workers and High Wage Firms”, Econometrica 67(2): 251–333.

Davis, S J and J Haltiwanger (2014), “Labor Market Fluidity and Economic Performance”, NBER working paper 20479.

Guiso, L, L Pistaferri, and F Schivardi (2005), “Insurance within the Firm”, Journal of Political Economy 113(5): 1054–1087.

Kline, P, N Petkova, H Williams, and O Zidar (2019), “Who Profits from Patents? Rent Sharing at Innovative Firms”, Quarterly Journal of Economics 134: 1343–1404.

Lamadon, T (2016), “Productivity Shocks, Long-Term Contracts and Earnings Dynamics”, unpublished manuscript.

Oi, W Y and T L Idson (1999), “Firm size and wages”, in O C Ashenfelter and D Card (eds), Handbook of Labor Economics Volume 3, part B, Elsevier: 2165-2214.

van Reenen, J (1996), “The Creation and Capture of Rents: Wages and Innovation in a Panel of UK Companies”, Quarterly Journal of Economics 111: 195–226.

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Topics:  Industrial organisation Labour markets

Tags:  labour market, wages, productivity

Assistant Professor of Strategy, Kellogg School of Management

Researcher in Economics, Institute for Evaluation of Labour Market and Education Policy

“Douglas A. Warner III” Professor of Economics, Yale University

Associate Professor of Economics at Stanford University

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