9/23/2009

Chapter 7

The Wage Structure

McGraw-Hill/Irwin
Labor Economics, 5th edition Copyright © 2010 The McGraw-Hill Companies, Inc. All rights reserved.

8-2

Introduction
• Two main reasons for observed wage dispersion: Some workers will earn
more than others because of
- productivity differences and
- differences in the rate of return to skills across labour markets and over time
(due to S&D shifts).

• This chapter considers the factors that contribute to the shape of the wage
and income distribution.

• We usually observe a long tail at the top end of the wage and income
distribution (including in NZ).

• US (and NZ) saw large increase in income inequality during 1980s and
1990s.
- Large increase in wage inequality between the ‘skilled’ and the ‘unskilled’.

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7-1 The US 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. Most workers earn low wages.

• Large international differences in income distributions (see

Table 7-1, p. 289).

• Some NZ evidence:
e idence:
- Statistics New Zealand (1999), Income Distribution in New Zealand,
Key Statistics, May, pp. 7-9. (Class handout)
- Ministry of Social Development (2008), Social Report 2008 – Income
Inequality. (2 page class handout)

8-4

Figure 7-1: The Wage Distribution in the

United States, 2006

15

12

9
Percent

0
0 500 1,000 1,500 2,000 2,500 3,000

Weekly Earnings

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Some General Facts About the Earnings

Distribution

• According to human capital theory,

theory 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.
- High-ability workers earn more both because they have more ability
and because they acquire more human capital (Figure 7-2).

8-6

Figure 7-2: Income Distribution When

Workers Differ in Ability
Rate of
Interest MRRL MRRH
MRR*

HL H* HH

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7-2 Measuring Inequality

• The standard measure of the extent of inequality in an income
distribution:
- The Lorenz Curve: It shows the cumulative share of income
going to the various quintiles (i.e. 20% shares) of
households.
• The more inequality, the further is the actual Lorenz curve from the
45 degree line (the ‘perfect-equality’ Lorenz curve).
• The Gini coefficient ((note: it can,, and has been,, applied
pp to many
y
types of income-related data) .
- ‘0’ if perfect equality; ‘1’ if perfect inequality.
- Problem: Different household income distributions can result in
the same Gini coefficient.
- Supplementary measures: 90-10 wage gap; 80-20 wage gap, 50-
10 wage gap, etc.

8-8

Figure 7-3: The Lorenz Curve and the

Gini Coefficient
The “perfect-equality”
B
1
Lorenz-curve is given
by the line AB,
0.8 indicating that each
Perfect-equality
Lorenz curve quintile of households
Share of income

0.6 gets 20 percent of

aggregate income, while
0.4 the Lorenz curve
Actual
Lorenz curve
describing the actual
02
0.2 income distribution lies
below it. The ratio of
A
0 C the shaded area to the
0 0.2 0.4 0.6 0.8 1 area in the triangle ABC
Share of households
gives the Gini
coefficient.

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7-3 Changes in the US Wage Structure –

the 1980s & 1990s
• The wage gap between those at the top of the wage distribution
andd those
th att the
th bottom
b tt widened
id d dramatically.
d ti ll
• Wage differentials widened among education groups,
experience groups, and age groups.
• Wage differentials widened within demographic and skill
groups.
• Reasons? Some of it due to increase in return to schooling &
experience (Figure 7-5).
• Also large increase in within skill group inequality, i.e. rise in
income inequality between similar workers!

8 - 10

Figure 7-4a: Earnings Inequality for Full-Time, Year-

Round Workers, 1963-2006: The Gini Coefficient

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8 - 11

Figure 7-4b: Earnings Inequality for Full-Time, Year-

Round Workers, 1963-2006: The 90-10 Wage Gap

450

400
Men
Percent wage gap

350

300
Women

250

200

150
1960 1970 1980 1990 2000 2010

Year

8 - 12

Figure 7-4c: Earnings Inequality for Full-Time, Year-

Round Workers, 1963-2006: The 50-10 Wage Gap

150

130
Percent wage gap

Men
110

90 Women
P

70

50
1960 1970 1980 1990 2000 2010

Year

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8 - 13

Figure 7-5: Wage Differential Between College

Graduates and High School Graduates, 1963-2006

8 - 14

7-4 Policy Application: Why Did Wage

Inequality Increase?

• Much of the material in this section is also relevant for

countries other than the US. You should focus on the different
possible reasons for wage inequality.

• No single factor explains all of the observed changes in income

inequality.

• The increase in US inequality seems to have been caused by

concurrent changes in economic “fundamentals” and labour
market institutions.

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8 - 15

Changing the Wage Structure

• Simple
p demand & supply
pp y model explanations:
p
- Assume just two types of workers: Skilled and unskilled.
- Wage ratio between skilled and unskilled workers: ‘r’.
- Ratio of number of skilled to unskilled workers: ‘p’
(not constant in the long-run, but here assumed constant).

- See Figure 7-7:

7 7:
• Demand curve gives demand for skilled workers
relative to demand for unskilled workers.
• Perfectly inelastic relative supply of skilled workers.

8 - 16

The Simple Demand & Supply Model ctd.

- In this simple model, only two ways that the wage gap r
could have increased:
• Decrease in supply of skilled workers will cause
widening of wage gap.
• Increase in demand for skilled workers will cause
widening of wage gap.

- What actually happened in US: Large increase in the

relative supply of skilled workers. Therefore, there must
also have been a large outward shift of the relative
demand curve for skilled workers, ceteris paribus.

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8 - 17

Figure 7-7: Changes in the Wage Structure

Resulting from Shifts in Supply and Demand

The downward-sloping demand curve

implies that employers wish to hire
S0 S1
Relative Wage of relatively fewer skilled workers when the
Skilled Workers relative wage of skilled workers is high.
The perfectly inelastic supply curve
indicates that the relative number of skilled
workers is fixed. Initially, the labour
r1 C
market is in equilibrium at point A.
r0 A Suppose the relative supply of skilled
workers increased to S1. The rising relative
wage of skilled workers can then be
D1 explained only if there was a sizable
B
D0
outward shift in the relative demand curve
(ending up at point C).
p0 p1 Relative Employment
of Skilled Workers

8 - 18

Possible Explanations

• Search
Sea c foro explanations:
e p a at o s: What
W at factors
acto s might
g t explain
e p a a large
a ge
enough increase in relative demand for skilled workers to
overcome the impact on r of the increase in relative supply
of skilled workers?

• Supply shifts:
- They cannot explain the ‘big picture’ of what happened to
the wage
age str
structure,
ct re bbutt the
they can explain
e plain the fall in the relative
relati e
wage of skilled workers’ wages during the 1970s!
- Some of the relative decline in high-school drop-out wages
also due to immigration of mostly unskilled workers, i.e.
high-school drop-outs (explains about one-third).

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8 - 19

Possible Explanations ctd.

• Demand shifts:
- International Trade
• Has it increased demand for skilled workers? Are workers employed in
export industries (on average) better educated than workers in import
industries? Depends on structure of exports and imports! In the US, foreign
trade seems to have contributed modestly (20%) to the rise in wage
inequality. NZ evidence? Did trade hurt or benefit unskilled and/or low
skilled workers?

- Skill-Biased Technological Change (often seen as the main

explanation)
• Technological change and skilled work are likely to be complements.
• Technological change and unskilled work are likely to be substitutes.

8 - 20

Possible Explanations ctd.

- Example: Personal computer (PC) use often thought to be

positively correlated with increased demand for skilled workers
and higher wages for such workers. But: Measurement is an
issue, and so is causality. For example, some critics of the US
case argue that much of the increase in inequality occurred
before the major increase in PC use.

• The effects of PC and, more generally, ICT (Information &

Communication Technology) use are an active area of economic
research.

• Some NZ evidence: Blumenfeld and Thickett (2003), Daldy and

Gibson (2003)(full references are listed on p. 3 of your
‘Supplementary Reading List’)

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Possible Explanations, ctd.

- Institutional Changes
• D
Decline
li in i union
i membership
b hi (de-unionisation).
(d i i ti ) Weakened
W k d
bargaining power of unions in US (& in NZ during ‘Employment
Contracts Act’ era!). This can be interpreted as a relative outward
shift in the relative demand curve for skilled labour (Figure 7-7).
• Minimum wage fell in real terms (in U.S.), thereby increasing wage
gap between unskilled and skilled workers.
- But cannot explain widening gap between and within different groups
of skilled workers.

• Summary: None of the (at least five) factors mentioned can

explain all of the observed changes (including their timing) in
the US wage dispersion.

8 - 22

Possible Explanations, ctd.

• Also large
g differences in international trends in wage
g inequality
q y
(see Table 7-4).
- Differences in labour market institutions.
- Maybe some countries responded to the increased demand for
skilled workers by changing prices (i.e. lowering unskilled
wages; US, UK, NZ, Australia), whereas other countries
responded by changing quantities (i.e.
(i e higher unemployment of
unskilled workers; Canada, Germany, Norway?).
- There is still much to learn about what caused the changes in
wage/income inequality observed during the last two or three
decades!

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8 - 23

Some More NZ-Specific Literature & Evidence

• My paper “Towards a Knowledge Economy? Changes in New Zealand’s

Information Work Force 19761976-1996”,
1996 , Prometheus, Vol. 18, No. 3, 2000, pp.
265-282 (especially the section on ‘The changing income distribution’).

• Dixon, Sylvia (1998), “Growth in the dispersion of earnings: 1984-97”,

Labour Market Bulletin, Issue 1&2, pp. 71-107.
- Largest component of rise in earnings disperson came from increased inequality
within groups of workers with similar observed levels of education, age and
potential work experience.
- Earnings
g inequality
q y mainly
y rose before 1991,, i.e. role of Employment
p y Contrasts
Act is unclear.

• O’Dea, Des (2000), ‘The Changes in New Zealand’s Income Distribution’,

Treasury Working Paper 00/13, Wellington.
- Importance of social trends, i.e. changes in household composition (growth in
sole parent households and older household without children); more skilled
workers.

8 - 24

Some More NZ Literature & Evidence, ctd.

• Hyslop
Hyslop, D.
D and D.
D Mare (2005),
(2005) “Understanding
Understanding New Zealand’s
Zealand s Changing
Income Distribution, 1983-1998: A Semi-parametric Analysis”, Economica,
72, pp. 469-495.

• Atkinson, A. B. and A. Leigh (2005), The Distribution of Top Incomes in

New Zealand, Centre for Economic Policy Rearch Discussion Paper No.
503, Australian National University, Canberra, November.

• Statistics New Zealand (2007), Wealth Disparities in New Zealand,

Wellington, April.

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7-5 The Earnings of Superstars

• What determines the economic rewards at the very

top of the wage distribution?
- Superstar phenomenon: A few persons in some professions
earn very high salaries and seem to dominate their field.
- Pre-conditions for ‘superstar’ incomes:
1. Even if a job is the same, different people bring different skills to
the same job,
job i.e.
i e some (a few) people are very talented at what
they do. “Sellers are not perfect substitutes”.
2. The technology of mass production allows the very talented to
reach very large markets (at very low price).
1 not enough! 2 is crucial!

8 - 26

7-6 Inequality Across Generations

• Degree of social mobility in a society?

• There is a correlation between the skills of parents and their
children: “Parents usually care about the well-being of their
children”. Implies that high-income parents will typically invest
more in the education of their children compared to low-income
parents.
• There is a tendency for income differences across families to
get smaller over time ((“regression
regression toward the mean
mean”)). In terms
of Figure 7-8, the intergenerational correlation (slope of the
line) is less than 1 but greater than 0.
- Three possible reasons for regression toward the mean (p. 309).

• US not as socially mobile as previously believed.

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Figure 7-8: The Intergenerational Link in Skills

The slope of the regression line Earnings of

Children A Slope
A, Sl =1
linking the earnings of the
children and the earnings of the
parents is called an
C, Slope is between 0 and 1
intergenerational correlation. If
the slope is equal to 1, the wage
B, Slope = 0
gap between any two parents
persists entirely into the next
generation and there is no
generation,
regression toward the mean. If
the slope is equal to 0, the wage 45°
of the children is independent of Earnings of Parents
the wage of the parents, and
there is complete regression
toward the mean.

8 - 28

Inequality Across Generations ctd.

For recent international evidence,, includingg data on NZ,, see:

D’Addio, Anna Cristina (2007), “Intergenerational

Transmission of Disadvantage: Mobility or Immobility across
Generations” A Review of the Evidence for OECD Countries”,
OECD Social, Employment and Migration Working Papers No.
52, Paris.
http://www.oecd.org/dataoecd/27/28/38335410.pdf

End of Chapter 7

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