1. McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 8 The Wage Structure

2. Outline of Chapter 8 The earning distribution Measuring inequality The wage structure: basic facts Policy application: Why did wage inequality increase? The earnings of superstars Inequality across generations

3. Introduction The supply and demand for workers and skills determine the structure of wages in the economy—the rewards for work and human capital investments.

4. 8-4 Introduction Some workers will earn more than others Productivity differences Rate of return to skills will differ This chapter considers the factors that contribute to the shape of the wage distribution

5. 8-5 The earnings distribution The wage distribution is positively skewed (long right tail) A small percent of workers earn disproportionately large shares of the rewards for work

6. 8-6 The Wage Distribution in the United States, 2002

8. 8-8 Facts about the earnings distribution Wage differentials exist due to Human capital investments that vary from worker to worker Age (young workers are still accumulating human capital, older workers are collecting returns from earlier investments There is a positive correlation between ability and human capital investments, which “stretches out” wages in the population

10. Measuring inequality Calculations of how much income goes to particular segments of the distribution. Lorenz curve reports the cumulative share of income accruing to the various quintiles of households. The “ perfect equality” Lorenz curve is a straight line with a 45 degree

11. 8-11 The Lorenz Curve and the Gini Coefficient The “perfect-equality” Lorenz-curve is given by the line AB, indicating that each quintile of households gets 20 percent of aggregate income, while the Lorenz curve describing the actual income distribution lies below it. The ratio of the shaded area to the area in the triangle ABC gives the Gini coefficient. A B C Actual Lorenz curve Perfect-equality Lorenz curve

13. Gini Coefficient To measure inequality Gini coefficient=

14. Gini coefficient = 0 when perfect equality = 1 when perfect inequality Drawbacks: summarize the entire shape of the income into a single number.

15. Additional measures of inequality 90-10 wage gap: gives the percent wage differential between the worker at the 90th percentile and the worker at the 10th percentile of the income distribution. 90-10 wage gap provides a measure of the range of the income distribution

16. Additional measures of inequality 50-10 wage gap: gives the percent wage differential between the worker at the 50th percentile and the worker at the 10th percentile 50-10 wage gap provides a measure of inequality between the “middle class” and low-income workers.

17. 8-17 Changes in the wage structure – the 1980s The wage gap between those at the top of the wage distribution and those at the bottom widened dramatically Wage differentials widened among education groups, experience groups, and age groups Wage differentials widened within demographic and skill groups. In other words, the wages of workers of the same education, age, sex, occupation, and industry were much more dispersed in the mid-1990s than were in the late 1970s.

19. 8-19 Wage Differential Between College Graduates and High School Graduates, 1963-2001

20. 8-20 Trend in the “Residual” 90-10 Wage Gap, 1963-2001

21. 8-21 Why did wage inequality increase? No single factor explains the changes The increase in inequality seems to be caused by concurrent changes in economic “fundamentals” and labor market institutions

22. 8-22 Changes in the Wage Structure Resulting from Shifts in Supply and Demand Relative Wage of Skilled Workers Relative Employment of Skilled Workers A S1S1 S0S0 D0D0 D1D1 B C p0p0 p1p1 r0r0 r1r1 The downward-sloping demand curve implies that employers wish to hire relatively fewer skilled workers when the relative wage of skilled workers is high. The perfectly inelastic supply curve indicates that the relative number of skilled workers is fixed. Initially, the labor market is in equilibrium at point A. Suppose the relative supply of skilled workers increased to S 1. The rising relative wage of skilled workers can then be explained only if there was a sizable outward shift in the relative demand curve (ending up at point C).

23. 8-23 Changing the wage structure Decrease in supply of skilled workers will cause widening of wage gap Increase in demand for skilled workers will cause widening of wage gap

25. Implication The supply-demand framework clearly shows that any attempt to understand the rise in the relative wage of skilled workers must identify factors that increases the relative demand for skilled labor. The rightward shift in the demand curve must have been sufficiently large to outweigh the impact of the increase in the relative supply of skilled workers.

26. Possible factors that widened the wage gap (I)-Supply Shifts Entry of the relatively well educated Baby boom cohort in the1970s Increase in the number of unskilled immigrants in the 1980s. labor market. Nearly 25 million legal immigrants were admitted between 1966 and 200, and additional 8 million foreign-born person lived in U.S. illegally in 2000

27. 8-27 Possible factors that widened the wage gap (II) Globalization Globalization of U.S. economy (international trade) The ratio of exports and imports to GDP: 8 percent in 1970 and 19 percent in 1996. By 1996 nearly 40 percent of all imports come from less-developed countries The internationalization-with rising exports and even more rapidly rising imports- have a beneficial impact on the demand for skilled workers and an adverse impact on the demand for unskilled workers Explain less than 20 percent of the increase

28. Possible factors (III) Skill-biased technology change Technological advances are good substitutes for unskilled workers and complement the skills of highly educated workers. (personal computer) Explain most of the increase in wage inequality

29. Possible factors (IV) Institutional changes The weakening bargaining power of unions can be interpreted as an outward shift in the relative demand for skilled labor (explain about 10 percent) Decline in the real minimum wage

30. Problems with the existing explanations Immigration or trade can explain the increasing wage gap between skilled and unskilled workers, but fail to easily explain inequality within skilled group. Stability of the minimum wage explain the falling real wage of low-skill workers, but fail to explain the rising real wage of high-skill workers Skill-biased technological change is not easy to quantify.

31. puzzle The wage structure of different developed countries did not evolve in similar way over the past two decades. Safety-nets designed to protect the well- being of low-skill workers (European countries)

34. Table 1.Average changes in real hourly wages, labor supply, human capital for full-time prime-age males in Taiwan 1979-2001. Year Skilled groups Wage (percentage) Labor supply (percentage) Education (ten thousand) Working experience (ten thousand) 1979 | 1987 High- Skilled workers 5.094.23 16.6310.14 Medium- Skilled workers 4.137.7583.1185.39 Low- Skilled workers 4.490.8432.0651.01

35. YearDemograph ic groups Wage § (percentage ) Labor supply § (percentage) Education ¥ (ten thousand) Working experience ¥ (ten thousand) 1988 | 1993 High- skilled workers 6.13 5.16 34.25 28.49 Medium- skilled workers 7.685.70113.54151.42 Low- skilled workers 9.05 -1.27 7.59 -28.98 Table 1 continued.

36. YearDemographic groups Wage § (percentage) Labor supply § (percentage) Education ¥ (ten thousand) Working experience ¥ (ten thousand) 1994 ︳ 2001 High-skilled workers 2.05 4.3044.4238.79 Medium- skilled workers 0.472.4476.29136.38 Low-skilled workers -0.01 -4.40-45.66-197.36 Table 1 continued.

38. 8-38 The earnings of superstars Superstar phenomenon – a few persons in some professions earn very high salaries and seem to dominate their field This suggests that even if a job is the same, different people bring different skills to the same job Skills are not perfect substitutes and because we demand the best, those workers who are lucky enough to have exceptional abilities will command relatively high salaries. The superstar phenomenon requires that sellers are not perfect substitutes and that the technology of mass production allows the very talented to reach very large markets.

39. Inequality across generations Whether wage inequality in a particular generation is transmitted to the next generation- social mobility Parents care both about their own well-being and about the well-being of their children. Parents will invest in their children’s human capital. The investment from parents create the link between the skills of parents and the skills of their children

40. 8-40 Inequality across generations There is a correlation between the skills of parents and their children High-income parents will typically invest more in the education of their children There is a tendency for income differences across families to get smaller over time (“regression toward the mean”)

41. 8-41 The Intergenerational Link in Skills Earnings of Children Earnings of Parents 45  A, Slope = 1 B, Slope = 0 C, Slope is between 0 and 1 The slope of the regression line linking the earnings of the children and the earnings of the parents is called an intergenerational correlation. If the slope is equal to 1, the wage gap between any two parents persists entirely into the next generation, and there is no regression toward the mean. If the slope is equal to 0, the wage of the children is independent of the wage of the parents, and there is complete regression toward the mean.

42. Inequality across generations The intergenerational correlation is less than 1. The possible attenuation of the differences in skills or incomes across generations is known as regression toward the mean

43. regression toward the mean may arise because parents do not devote their entire wealth to investing in their children’s human capital Parents encounter diminishing return when they invest in their children’s human capital There is probably some regression toward mean in ability

44. 8-44 Social capital The quality of the environment where a child grows up helps determine human capital There is evidence that varied factors influence a child’s level of human capital Quality of neighborhood Importance of religious organizations Socioeconomic background of classmates

45. End of Chapter 8 McGraw-Hill/Irwin Copyright © 2005 by The McGraw-Hill Companies, Inc. All rights reserved.