How Much Do Wages Go Up When Profit Increases by a Dollar?

Given the interest in the rise of robots, shrinking labor shares and the owners of capital, I thought I’d highlight a Van Reenen paper that David Card suggested we read on the link between firm profitability and wages. It looks at at how firms share quasi rents from successful technological innovations. Since it’s gated, I pasted some of the introduction as well.

ABSTRACT: This paper examines the impact of technological innovation on wages using a panel of British firms. A head-count measure of major innovations between 1945 and 1983 is combined with share price and accounting information. Innovating firms are found to have higher average wages, but rival innovation tends to depress own wages. This appears consistent with a model where wages are partly determined by a sharing in the rents generated by innovation. In other words, innovation may be a good instrument for proxies for rents such as profitability, quasi rents, or Tobin’s (average) Q. Instrumental variable estimates of the elasticity between wages and quasi rents are about 0.29. 

Introduction:

Economists have traditionally been concerned that employees will try to cream off the fruits of technological innovation into higher earnings. It is often argued that this process is likely to reduce a firm’s incentive to innovate and therefore to damage economic growth. Labor leaders, however, often explicitly argue for the benefits of linking pay to technical progress. As John Hodge, former General Secretary of the U. S. Smelters put it: “we won’t work against the machine if we get a fair share of the plunder” [Elbaum and Wilkinson 1979]. The argument that giving away “fair shares” can enhance labor productivity for efficiency wage reasons has recently been taken up theoretically and empirically by Akerlof and Yellen [1990].

This paper examines the response of company wages to observed technological innovations using a unique panel data set. Whichever way the data are cut, innovation is seen to lead to significantly higher wages in a sample of almost 600 firms. Different explanations are offered for this result, but the most plausible interpretation appears to be that there is a sharing of the quasi rents from innovation between workers and firms.

The view that wages are determined partly by sharing in quasi rents has become increasingly popular among labor economists. Some researchers have stressed labor market rents generated through efficiency wages [Krueger and Summers 1988] or from firm-specific job matches. Others emphasize features of the product markets in which firms operate. One common empirical approach relies on entering various proxies for above-normal economic returns in a reduced-form wage equation.1 As forcefully stated in a recent contribution by Abowd and Lemieux [1993], endogeneity is a major problem in such studies. In their applica- tion Abowd and Lemieux use industry import and export prices as instruments for quasi rents. They find very large downward biases on OLS estimates of the quasi-rent splitting parameter. Unfortunately, they could not find significant effects after controlling for common macroeconomic shocks. This is likely to be because their instrument does not vary between firms and relies on industry level time variance for its power. The alternative source of rents examined in this paper are firm- and industry-specific technological innovations. These vary between firms and over time and are sufficiently rare to qualify as natural experiments picking out shifts in quasi rents.

Innovative rents are understood here in their Schumpeterian sense of being the reward for the first commercialization of an invention. They occur at an earlier stage in the product life cycle than technical diffusion. A firm adopting a new technology through diffusion is unlikely to generate substantial rents as it will have to pay a market price to purchase the new techniques. But why would rational employees appropriate quasi rents if this reduced the incentives of firms to search for innovation through R&D?There are three reasons why larger portions of innovative returns are seen as legitimately “up for grabs” by workers: (i) the long lag times between research and results compared with tan- gible capital, (ii) the shorter time horizons of workers than shareholders (perhaps because of the finite duration of labor contracts), and (iii) the large elements of sheer luck in innovative success (for further elaboration of this view see Hirsch [1991]).

As well as making a rent-sharing story more plausible, the emphasis on innovation rather than diffusion taken in this paper distinguishes it from related empirical work on wages and technical change. This literature relates wages to various proxies for technology such as computers or other microelectronic technologies (see Krueger [1992], Dunne and Schmitz [1995], and Entorf and Kramarz [1994]), the age of technology (e.g., Bartel and Lich- tenberg [19901), or Solow residuals [Nickell, Vainiomaki, and Wadhwani 1994]. Positive effects are generally observed in these studies as they are when industry research and development ex- penditures are used as an explanatory variable of individual wages from the Current Population Survey [Dickens and Katz 1987].

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About ozidar

Graduate student at UC Berkeley, studying public finance & labor economics. https://sites.google.com/site/omzidar/
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8 Responses to How Much Do Wages Go Up When Profit Increases by a Dollar?

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  7. nemi says:

    “Economists have traditionally been concerned that employees will try to cream off the fruits of technological innovation into higher earnings.”

    Sometimes you don’t know whether you should laugh or cry. The employees, who reasonably is the ones who create and implement the innovation, will cream of the result from their work. Oh – the humanity!

  8. darius says:

    Link to the paper refers to Krugman’s blog. Was that intended?

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