UNEMPLOYMENT, LABOR MARKET TRANSITIONS, AND RESIDUAL WAGE DISPERSION
| Date | 01 November 2008 |
| Author | Bernd Fitzenberger,Alfred Garloff |
| DOI | http://doi.org/10.1111/j.1467-9485.2008.00466.x |
| Published date | 01 November 2008 |
UNEMPLOYMENT, LABOR MARKET
TRANSITIONS, AND RESIDUAL WAGE
DISPERSION
Bernd Fitzenberger
n
and Alfred Garloff
nn
Abstract
It is commonplace in the debate on Germany’s labor market problems to argue that
low wage dispersion is a major reason for the high unemployment rate. This paper
analyzes the relationship between unemployment and residual wage dispersion for
individuals with comparable attributes. In the conventional neoclassical point of
view, wages are determined by the marginal product of the workers. Accordingly,
increases in union minimum wages result in a decline of residual wage dispersion
and higher unemployment. A competing view regards wage dispersion as the
outcome of search frictions and the associated monopsony power of the firms.
Accordingly, an increase in search frictions causes both higher unemployment and
higher wage dispersion. The empirical analysis attempts to discriminate between
the two hypotheses for West Germany analyzing the relationship between wage
dispersion and both the level of unemployment as well as the transition rates
between different labor market states. The findings are not completely consistent
with either theory. However, as predicted by search theory, one robust result is that
unemployment by cells is not negatively correlated with the within-cell wage
dispersion.
I Intro ductio n
It is commonplace in the debate on Germany’s labor market problems to argue
that low wage dispersion as an indicator of low wage flexibility is a major reason
for the high unemployment rate, see Sachversta
¨ndigenrat zur Begutachtung der
Gesamtwirtschaftlichen Entwicklung (2005) and OECD (2006). In international
comparison, wage inequality in Germany is small and remained fairly stable
until the late 1990s, see Prasad (2004). According to the Krugman (1994)
hypothesis, the increase of wage inequality in the United States and the increase
of unemployment in Germany are two sides of the same coin, namely, the
response to the pertinent skill bias in labor demand. Accordingly, wage rigidities
caused by wage bargaining institutions (unions) have prevented wage inequality
n
Albert-Ludwigs-University Freiburg, IFS, IZA, ZEW
nn
ZEW, IAB
Scottish Journal of Political Economy, Vol. 55, No. 5, November 2008
r2008 The Authors
Journal compilation r2008 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
561
to rise in Germany thus resulting in higher unemployment. The rationale for this
argument is that if wages are set above the marginal productivity of workers,
firms do not employ some of the least productive workers.
Given the production technology and the skill bias, human capital theory
explains wage differentials by concentrating on the role of individual,
productivity-relevant traits (human capital). If individuals are paid as in a
competitive human capital model, we expect that wage differentials stem only
from differences in individual traits. Wages, however, differ between observa-
tionally equivalent workers. We call these differences residual wage dispersion
and postulate that, if the human capital approach to wages is correct, the
residual wage dispersion is explained by unobserved productivity differences.
From an empirical point of view, one can control for a part of this residual
variation if allowing for effects that come from specific firms (‘high wage firms,’
see Abowd et al., 1999) or from specific industries. This observation challenges
the classical human capital model, which assumes perfect competition and which
allows neither for firm-specific differences nor for industry-specific effects,
except for the case that the unobserved productivity differences are correlated
with firms or specific industries.
1
Search theory offers both an interesting alternative and complement to
marginal productivity theory and human capital theory by focusing on search
frictions as an explanation for wage differences among workers with identical
marginal productivity. The basic idea of search theory is that under imperfect
information, there is a match-specific rent because of opportunity costs of
waiting for a better match. Then, the wage is not unique and does not necessarily
correspond to the marginal product. Equally productive workers face different
possible wages (or even a whole distribution) for which they could work. Under
this perspective, the reason why firms pay different wages is that search frictions
lend them monopsony power, which they can exploit to different degrees. On the
one hand, there might be high-wage firms that have to pay high wages in order
to assure their high employment. On the other hand, there might be low-wage
firms that employ only a small number of employees because they lose them at a
fast rate to their better paying competitors. Wage decompositions that try to
identify the effect of search frictions on the basis of search equilibrium models
attribute a considerable amount of the wage variation to search frictions.
2
Search equilibrium models themselves predict a close association between wages
and labor market transitions. When implementing these models empirically, a
lot of identifying and nontestable assumptions typically have to be imposed on
the data (see e.g. Van den Berg and Ridder, 1993, 1998; Bontemps et al., 2000).
We follow a slightly different approach here. Starting with the Krugman
(1994) hypothesis that the relatively small wage dispersion in Europe might be
1
In the classical framework, high wage firms might have attracted high ability individuals.
However, empirical evidence even supports the contrary. Abowd et al. (2002) and Gruetter and
Lalive (2004) find that person and firm effects are negatively correlated.
2
By search equilibrium models, we refer to a class of models based on search frictions, which
explicitly model the decision problem of both sides of the labor market and which imply an
endogenous wage distribution.
BERND FITZENBERGER AND ALFRED GARLOFF562
r2008 The Authors
Journal compilation r2008 Scottish Economic Society
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