Why does inequality grow? Can we do something about it?

Coen Teulings, 15 June 2014

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Over the past couple of years, the OECD has highlighted the rapidly widening income dispersion in OECD countries (see e.g. OECD 2008, OECD 2014). The recent publication of Thomas Piketty’s Capital in the 21st Century, gave new impetus to this debate.

Recently, there have been large shifts in the distribution of total income, both from labour to capital and, within the labour share, from low- to high-earning workers. This growing inequality has a large impact on many aspects of society, from diverging educational opportunities, to the distribution of health and overall well-being. Though there are marked differences between countries, the rise in inequality has been a general phenomenon. Hence, there is a quest for more inclusive strategies that allow larger parts of society to benefit from the growth of GDP.

Causes of income inequality

There has been much debate on the causes of this trend.

  • At the turn of the century, skill-biased technological progress was considered to be the main culprit.

The skill bias in the change in production technology reduced the demand for high school dropouts and raised that for college graduates. To the extent that the education system could not keep pace with the increased demand for graduates, the skill premium soared.

The rapid pace of technological progress means that we are moving increasingly to a ‘the-winner-takes-it-all’ society, where early entrants in new industries capture an incredible amount of rents, with Microsoft, Google, and Facebook as the most extreme examples. This has contributed to a steady shift in the distribution of income from labour to profits.

  • More recently, the attention has shifted to the role of globalisation.

Where the share of the BRIC countries in the world economy was too small to account for the large shifts in relative wages during the 1990s, this share has grown so rapidly in the last two decades that its impact on the income distribution can no longer be ignored. However, this impact of globalisation is more subtle than an outright increase in inequality. For the BRIC countries, globalisation leads to a large increase in GDP, and thus a large improvement in the standards of living for the majority of their population.

For the developed countries, the effect of globalisation on their income distribution is more subtle; the wage distribution becomes increasingly skewed to the right. The wages of low- and medium-educated workers become more and more similar, forming a large mass on the left-hand side of the income distribution, while the share of the top 10% in total income skyrockets, leading to a long and fat tail from right to left of the distribution.

Specifically:

  • The middle class loses (see Autor et al. 2013).

The middle class is employed in exactly the types of job that both face fierce global competition and are highly vulnerable to automation. Demand for workers with intermediate levels of education falls, and hence their wage surplus above workers with lower education. Despite the overall growth, the real wage of the median worker in the US has fallen since 1990.

  • The upper class commands specialised human capital that is in high demand in a technology-driven world.
  • The lower class is mainly employed in personal services that are non-tradable and cannot be imported from the BRIC countries.

Moreover, jobs in these industries are less sensitive to technological innovation than jobs in manufacturing.

From a policy perspective, this diagnosis poses new challenges. The old story for emancipation relied on investment in human capital; for the lower strata of society, education was the best means for improving their position. The future of your children was safeguarded most effectively by better education, so you were encouraged to make sure that they put all their efforts into obtaining the best possible degree. That story no longer applies to everybody. It still applies to the upper tail of the distribution of educational attainment, since the return to obtaining a degree from good university has gone up. However, it no longer applies to the lower tail of the distribution, since the return to completing high school, or adding some years of college, has gone down.

However, trade and technology are not the only explanations for the dramatic increase in inequality over the past couple of decades.

  • The liberalisation of labour market institutions since 1980 has also contributed substantially.

DiNardo, Fortin and Lemieux (1996) have shown that the fall in minimum wages and the demise of the unions increased inequality in the United States during the 1980s. Later work by Lee (1999) and Teulings (2003) suggests that a large part – if not all – of the rise in wage inequality in the lower half of the distribution is due to the fall in minimum wages during that period. This applies in particular to females, who earn lower wages, and for whom the minimum wage therefore has a larger impact. Starting from the low levels of the minimum wage that currently prevail in the US, the job-losses from an increase in that minimum are limited. This fits the recent experience of the UK, where the introduction of a minimum wage had a substantial effect on wage inequality, but hardly any effect on the chances of low-skilled workers finding a job. It might be different in France, where minimum wages are much higher to begin with. In that case, further increases in the minimum wage have large detrimental effects on the job opportunities for low-skilled workers.

  • Provided that they are not set too high, minimum wages therefore have a large effect on wage inequality, and a relatively small effect on employment.

The obvious question is then: What wage would be not too high? I use as a rule of thumb that a maximum of 4% of workers should earn the minimum wage. If more than 4% earn the minimum, job losses become substantial. However, there is no empirical evidence to support the rule of thumb other than the differences in outcomes between the US and France. Regrettably, the strategy of a limited increase in the minimum wage reaches this critical point of 4% earlier now that the wage differential between low- and medium-educated workers has fallen, and more workers earn close to the minimum wage.

Institutions and the labour market

Why are institutions so important for the labour market? Why would the free market not lead to the best possible outcome? Economists are gradually starting to understand why the institutions for wage setting matter so much. The standard auction model taught in Economics 1.01 is a bad representation of how labour markets actually operate. The auction model assumes that all job seekers and all firms with vacancies meet at the same place and time. A hypothetical auctioneer calls a potential wage rate, records the potential supply and demand at that wage, and then adjusts his call until he arrives at an equilibrium rate that sets supply equal to demand. Reality is different. Individual job seekers and firms meet and bargain bilaterally on an acceptable wage. If they fail to reach agreement, then both continue to search for other options. The point is that there is no auctioneer to set the wage; the worker and the firm have to agree between themselves. Hence, it is critical which of the two parties has the best bargaining skills -- the worker or the firm. There is no guarantee whatsoever that the free market will yield a proper distribution of bargaining power from the point of view of social well-being.

When the theoretical apparatus for analyzing these models was first developed by Pissarides (1990) and Burdett and Mortensen (1988) – who received the Noble prize for their work -- it looked as though, by a kind of divine miracle, the actual distribution of bargaining power was reasonably in line with the social optimum. Later on, Stevens (2004) showed that firms can save on their wage bill by using deferred compensation schemes. Workers get paid low wages initially, but receive higher wages after staying at the same firm for a couple of years. If the worker quits before, the firm does not have to pay these higher wages at any point. Deferred payment binds a worker to the firm and, thus, reduces the threat of outside competition. No practical person would be surprised by this result, because this is what we see employers do every day -- most wage contracts contain extensive experience and tenure scales. However, what is surprising is that these schedules shift the balance of power in favour of the employer beyond what is desirable from a societal point of view. Hiring a worker becomes too attractive. Firms start poaching workers from each other, leading to a waste of resources on recruitment activity, excess job mobility, and training costs to make workers familiar with their new job, which they are likely to quit shortly afterwards anyway due to new incoming job offers. This change in the balance of power might also have contributed to the shift of the distribution of total income from labour to capital.

Together with Gautier and Van Vuuren (2010), we have shown that even when firms don’t use Stevens’ seniority profiles, and instead offer a fixed flat wage contract, efficiency emerges only when there are strongly increasing returns to scale in job search, and when firms can commit to paying hiring premiums before even meeting a potential candidate. In all other cases, firms have too much bargaining power.

Robin and Postel-Vinay (2002) have shown that firms can use even more aggressive strategies, paying wage increases only when an outside firm threatens to poach its worker. A firm can then hire apprentices and other young workers for very low starting salaries, and wait for outside offers to these workers before paying any wage increase. Empirical evidence shows that this type of arrangement is indeed used in practice, in particular with low-skilled workers. This type of wage contract shifts the balance of power in favour of employers even more, so even further beyond the social optimum than in Stevens’ analysis.

In this type of environment, small institutional details in wage setting can have a large impact on the outcome. Hence, the wave of liberalisation of labour-market institutions in the 1980s and 1990s might have had a negative impact on society after all. It has made labour markets more flexible and thereby created many jobs, but beyond a certain point, the net effect of further liberalisation might be negative from a societal point of view. Both the Financial Times and the Economist expressed sympathy with the idea of raising the minimum wage in the United States and introducing it in Germany; this support might be well taken. There is likely to be some kind of an optimum degree of liberalisation of labour market institutions. In some instances, the world might have moved beyond that point.

References

Autor, David, David Dorn and Gordon Hanson (0213), “Untangling Trade and Technology: Evidence from Local Labor Markets”, NBER working paper 18938.

Burdett, Kenneth and Dale Mortensen (1988), “Wage differentials, employer size, and unemployment”, International Economics Review, Vol. 39, No.2, May, pp. 257-273.

DiNardo, John, Nicole Fortin, and Thomas Lemieux (1996), “Labor market institutions and the distribution of wages, 1973-1992: A semiparametric approach”, Econometrica, Vol. 64, No.5, September, pp. 1001-1044.

Gautier, Pieter, Coen Teulings, and Aico van Vuuren (2010), “On-the-job search, mismatch, and efficiency”, The Review of Economic Studies, Vol. 77, Issue 1, pp.245-272.

Lee, David (1999), “Wage inequality in the United States during the 1980s: Rising dispersion or falling minimum wage?”, The Quarterly Journal of Economics, Vol. 114, No.3, August, pp. 977-1023.

OECD (2008), Growing Unequal?: Income Distribution and Poverty in OECD Countries, OECD Publishing, 21 October.

OECD (2014), Society at a glance, Directorate for Employment, Labour, and Social Affairs, OECD.

Piketty, Thomas (2014), Capital in the 21st century, Harvard University Press.

Pissarides, Christopher (1990), Equilibrium Unemployment Theory, MIT Press.

Postel-Vinay, Fabien and Jean-Marc Robin (2002), “Equilibrium wage dispersion with worker and employer heterogeneity”, Econometrica, Vol. 70, No.6, November, pp. 2295-2350.

Stevens, Margaret (2004), “Wage-tenure contracts in a frictional labour market: Firms’ strategies for recruitment and retention”, The Review of Economic Studies, Vol. 71, pp. 535-551

Teulings, Coen (2003), “The contribution of minimum wages to increasing wage inequality”, The Economic Journal, Vol. 113, Issue 490, October, pp.801-833.

Topics: Poverty and income inequality
Tags: income inequality, minimum wage, wage-setting

Professor of Economics, University of Cambridge; and CEPR Research Fellow

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