ATTRACTING HIGH-PAYING JOBS TO A LOCAL ECONOMY BOOST WAGES FOR EVERYONE: New evidence from Germany of the potential of industrial policy

Attracting a high-paying industry to a region leads to higher wages across all industries in the local economy. That is the central message of research by Jeanne Tschopp, published in the August 2017 issue of the Economic Journal.

Suppose that Mercedes expands its production activities to a new region in Germany, thereby causing wages in the car industry to rise by 10%. The new study finds that this first-round effect would generate a second round of positive adjustments that would raise wages by 7% in all other industries in the region, irrespective of whether or not their activities are related to Mercedes.

These results have significant implications for discussions of industrial and regional policies aimed at boosting investments and igniting job growth.

Should city governments provide incentives – such as targeted local tax breaks – to attract businesses, to keep them and to encourage them to expand? This question is at the centre of every policy discussion about the economic development of cities.

The conventional view is that attracting good businesses will boost the local economy, reduce unemployment and even increase property values by creating more jobs within the concerned industries as well as industries upstream.

This view is for the most part motivated by the traditional ''Walrasian'' theory of the labour market, according to which wages and employment are determined within an industry, by supply and demand. A direct implication of this conventional view is that the wage benefits of attracting good businesses is generally limited to workers directly employed in those new businesses or in their upstream industries.

Instead, this research argues that the wage gains of attracting a high-paying industry are considerably larger as they extend to all other industries. The analysis is motivated by search and bargaining theory, a relatively new alternative framework based on the seminal work of economics Nobel laureate Christopher Pissarides.

The theory of search and bargaining predicts that wages are also determined outside an industry – that is, by options that workers have to work in other industries. These outside options are usually captured by an average of the wages across all industries in which workers could potentially be hired. The theory implies that any change in the industrial structure of a region will modify workers'' outside options and thereby affect wages in all industries.

While search and bargaining theory has been widely used to study unemployment, it has not been used as extensively to understand the wage and inequality outcomes of industrial policies. One reason for this is that in practice, it is difficult to quantify the effects of workers'' outside options on wages as both, outside options and wages, determine one another.

The novelty of the new research is to propose a new identification strategy to estimate the impact of workers'' outside options on wages. The strategy uses a unique database comprising social security data on workers in Germany. Identification is obtained by combining a triple-difference estimation with instrumental variables; it is based on data variation in employment and wages across industries, occupations and cities of Germany over the period 1977-2001.

The main finding of the research is that search and bargaining mechanisms are economically important; in the particular case of Germany, a 10% increase in the outside options of a worker generates a 7% wage increase.

In addition, the results indicate that a Walrasian framework can only explain on average 11.5% of the differential in the growth rates of wages across German regions. But a search and bargaining framework that accounts for the effects of workers'' outside options is capable of explaining nearly 70% of those wage growth differences.

Therefore, it appears that the traditional Walrasian theory of the labour market provides an incomplete picture of the potential wage gains (or losses) associated with attracting and keeping (or losing) good high-paying jobs in a local labour market. This research is important as it quantifies the effect of a channel that has long been ignored when evaluating the effects of industrial policies on wages.

''Wage Formation: Towards Isolating Search and Bargaining Effects from the Marginal Product'' by Jeanne Tschopp is published in the August 2017 issue of the Economic Journal. Jeanne Tschopp is at Ryerson University in Toronto. Her website is here: https://jtschopp.wordpress.com/