PRODUCTIVITY AND PAY: New evidence from Sweden on how workers earn higher wages

Workers'' wages are three times more responsive to changes in productivity shared across the industry in which their employer operates than to productivity developments within a single firm. What''s more, when workers find it easier to move jobs within the industry – they have ''outside options'' – sector-wide increases in productivity will lead to better pay for incumbent workers.

These are among the results of a study of pay and productivity in Sweden by Mikael Carlsson, Julián Messina and Oskar Nordström Skans, published in the September 2016 issue of the Economic Journal. Their finding that outside options can be a key determinant of wages even in a country where most workers are covered by collective agreements suggests that worker mobility may play an even more important role in the UK and the United States, where wage negotiations are more decentralised.

Does the productivity of your firm affect your pay? Standard microeconomic theory says no. Firms have no power over setting wages when markets are perfectly competitive. All they can do is hire as many workers as they need for each type of labour at their respective market wages.

This view obviously clashes with the perceptions of the casual observer. Some firms pay higher wages than others. In some cases, wage differences seem to exist to compensate for unpleasant conditions. For example, firms operating in risky environments, where workers need to stand for long hours, might have to pay higher wages to attract applicants. Other firms simply seem to be better for workers, paying higher wages and even offering other attractive amenities in the bundle.

Many strands of modern economic theory – including the work of 2010 Nobel laureates Peter Diamond, Dale Mortensen and Christopher Pissarides – predict wage differences across firms for identical workers. What does the empirical evidence tell us?

Two stylised facts have been corroborated by empirical studies in a multitude of countries and economic conditions. The first is that larger firms pay higher wages. The second is that more profitable firms share some of these profits with their workers in the form of higher wages.

The two set of facts are obviously interconnected, as it is often the case that larger firms make higher profits. The empirical evidence is very robust and shows that larger and more profitable firms pay higher wages not only because they attract more skilled workers. Identical workers are paid better if they work for these firms.

A question that has proven much more difficult to answer is what lies behind these facts. Is it that larger firms or more profitable firms pay higher wages because they are more productive? Or is it instead that they have an advantage because consumers have a preference for their products, and the extra profits generated by this demand are shared with workers?

The new study focuses on Swedish data and shows that changes in a firm''s productivity affect worker wages, but perhaps less than one might have initially thought. From one year to the next, a typical change in firm-level productivity explains around 25% of the observed change in workers'' wages. If you allow for a longer time span, the response increases, and changes in productivity can explain up to 50% of the observed wage changes.

These results suggest that there is a lot of space for other factors to affect wages. New consumer tastes and other demand factors for each firm''s products are primary candidates. Recent evidence suggests that changes in the demand for firms'' products matter more than firms'' productivity for other firm-level outcomes including firms'' closure, firms'' growth and their hiring and firing policies.

The new study offers a second insight. It turns out that workers'' wages are about three times more responsive to changes in productivity that are shared with other firms in the same industry than to productivity developments affecting a single firm in isolation.

The authors evaluate two competing hypotheses to provide an explanation. The first is the wage bargaining structure in Sweden, which takes place predominantly at the industry level. Unions may better help workers coordinate their efforts to extract a bigger share of the pie when the productivity improvement has been shared across most firms in the sector.

The alternative hypothesis operates through workers'' outside options. When a shock is shared across firms where workers'' mobility costs are low (for example, because they share some industry-specific human capital), the worker may have higher bargaining power to negotiate a wage increase since the threat to quit and go to work in another firm becomes more credible.

The researchers report that, perhaps not surprisingly, most worker mobility happens within sectors. A worker who changes employer has a 54 percentage point higher probability of returning to the same, narrowly defined sector.

Perhaps more surprisingly, the data support market forces as the main reason behind a larger response to industry shocks. The study shows that when the change in productivity is shared across firms within which worker mobility is high, the wage of incumbent workers is more likely to change.

Thus, outside options appear to be a crucial determinant of workers'' actual wages even in a country like Sweden where most workers are covered by collective agreements. In other contexts where wage negotiations are more decentralised (for example, the United States and the UK), this mechanism operating through workers'' outside options may be even more relevant.

''Wage Adjustment and Productivity Shocks'' by Mikael Carlsson, Julián Messina and Oskar Nordström Skans is published in the September 2016 issue of the Economic Journal. Mikael Carlsson and Oskar Nordström Skans are at Uppsala University. Julián Messina is at the Inter-American Development Bank.