Does product market competition increase wage inequality? Maria Guadalupe London School of Economics MIT

Motivation Increasing competition in product markets: Important deregulation period Globalization Fall in transport/information costs Increasing wage dispersion: Returns to skill Residual inequality, returns to unobserved ability Within 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 competition Being 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 program Exploit 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 ratios III b- Quasi-natural experiment 1: Exchange rate shock III 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, ; 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 costs Firms 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 substitutes Imperfect product market competition

Setting N firms produce in imperfectly competitive product markets θ Each hires one worker to produce, Max П (d i,θ)=(P i (θ)-d i )Y i (θ) –w(d i )  П (d i ; θ) –w(d i ) High skill workers can produce at lower costs d i 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 (d i,θ)=(P i -d i )Y i  П (d i ; 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 (d N ;θ)-b -this defines equilibrium wage schedule П (d N ;θ)-b= П (d i ;θ)-w(d i ) w(d i ) = П (d i ;θ)- (П(d N ;θ)-b) ~~ ~~ ~ ~

d П(d) b W Revenues and wages ~ П(d) ~ dNdN

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 dNdN П(d) =w(d) ~ П’(d) =w’(d) ~ ~

Increase in θ d П(d) b W W’ П(d)’ dNdN ~ ~ ~

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 ( ) –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 ( ): 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 skill Individual wage regressions ln(w ijkt )=α+ θ k C jt +X ijkt ’γ+d t +d k +d j +ν ijkt ν ijkt =η i +d kt +d kj +ε ijkt C jt: Product Market Competition Coeff. of interest: θ k [ θ k –θ k’ ] returns to skill change with PMC X ijkt Individual characteristics

III a- Relationship between concentration and returns to skill ln(w ijkt )=α+ θ k C jt +X ijkt ’γ+d t +d k +d j +ν ijkt ν ijkt =η i +d kt +d kj +ε ijkt η i Individual fixed effects: Identification from variation for same individual Accounts 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 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 exogenous Identify 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

1996 appreciation Prediction: Sectors with high openness will increase relative wages more. ln(w ijkt )=α+ θ k (post96 t *imp j ) + β k post96 t +δ k imp j +X ijkt ’γ+d t + d k + d j +η i + ε ijkt Post96 t : dummy equals 1 after 1996 Imports change endogenously with exch. rate changes : imp j average import penetration between 1993 and 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 (SENS j ) and before/after 92 (post92 t ) (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(w ijkt )=α+ θ k (post92 t *SENS j ) +X ijkt ’ γ+β k post96+δ k imp j +d t +d k +d j +η i +ε ijkt

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% experiment: 7% 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