# 3. The firm-level link between productivity dispersion and wage inequality: A symptom of low job mobility?

In many OECD countries, there are large and increasing productivity differences between firms, even within narrowly defined industries (Andrews, Criscuolo and Gal, 2016[1]; Syverson, 2011[2]) . At the same time, and as shown in Chapter 2, in these countries, differences in average wages between firms have also increased, explaining more than half of the overall increases in wage inequality. To some extent, such increases in between-firm wage differences reflect the sorting of workers with higher education and more experience into firms paying higher wages. But differences in wages between firms are large even for workers with similar characteristics, suggesting the existence of firm wage premia. Chapter 2 already suggested that increased dispersion in firm wage premia accounts for around two-thirds of increased between-firm wage inequality. This raises the question of the structural and policy determinants of the link between productivity and firm-level wage premia, with possibly large implications for wage inequality and the allocation of workers across firms.

A link between productivity and firm wage premia arises because workers are not perfectly mobile between firms. With limited job mobility, high-productivity firms need to pay high wages to attract workers while low-productivity firms may afford to pay low wages to workers who have limited outside job options. Job mobility, in the sense of voluntary job-to-job transitions rather than overall job churn, may be limited because there are costs for workers to search for jobs and for firms to hire workers due to labour market frictions (e.g. imperfect information on job opportunities or costs related to changing jobs), or because workers have preferences over non-wage characteristics of jobs, such as geographical location or working time flexibility (Manning, 2020[3]). At any given level of productivity dispersion, promoting job mobility would not only reduce wage premia dispersion between firms but also allow high-productivity firms to expand employment, thereby promoting the efficient allocation of labour and raising aggregate productivity.2

This chapter analyses firm-level pass-through of productivity to wage premia for 13 OECD countries over the period 1995-2017 to better understand the challenges for labour and product market policies that aim to raise aggregate productivity growth while pursuing equity goals. First, the chapter develops a conceptual framework to illustrate the channels shaping the link between productivity and wages at the firm level. Second, it analyses empirically the relevance of different channels using linked employer-employee data complemented with firm-level data. The empirical results suggest that the link between productivity and wages at the firm level is to an important extent shaped by the structure of labour and product markets, as well as wage-setting institutions:

• Policies that promote voluntary job mobility reduce wage dispersion between firms at any given level of productivity dispersion. Low rates of job-to-job mobility (a measure of voluntary worker transitions between jobs) and high employer concentration raise the pass-through of firm-level productivity to wages by giving firms some degree of monopsony power on wage-setting. Raising job-to-job mobility from the 20th percentile of countries covered by the analysis (corresponding roughly to Greece) to the 80th percentile (corresponding roughly to Sweden) would reduce overall wage inequality by about 15%. To put this reduction in perspective, the median increase in wage inequality across countries over the period 1995-2015 was around 10% (Chapter 2).3

• Policies that promote product market competition amplify the effect of productivity dispersion on wage dispersion between firms. With strong product market competition, a given difference in productivity between firms implies a larger difference in output and employment between them. At any given level of job mobility, high-productivity firms need to pay high wages relative to low-productivity firms to attain their desired level of employment. However, the upward effect of product market competition on the pass-through of productivity to wage premia may partially or fully be offset if it raises opportunities for job mobility, including through the market entry of new firms.

• More centralised collective bargaining (e.g. sector-level bargaining) and higher minimum wages reduce productivity pass-through and wage premia dispersion between firms, but risk reducing employment if wage floors are set too high. With limited job mobility, low wages in low-productivity firms may partly reflect monopsonistic wage-setting by employers so that raising wage floors through more centralised collective bargaining or higher minimum wages may not necessarily reduce employment. However, setting wage floors in excess of workers’ productivity risks reducing employment. This risk could be reduced by combining centralised collective bargaining with sufficient scope for further negotiation at the firm level, and focusing minimum wage increases on areas and groups for which initial levels of wages are low.

The results in this chapter have a number of implications for public policies aimed at promoting productivity growth while limiting wage inequality, especially in the wake of the COVID-19 crisis that may require significant reallocation of workers from distressed firms to those with better growth prospects (Barrero, Bloom and Davis, 2020[4]). The main implication is that policies promoting job mobility, notably by eliminating unnecessary labour market frictions, can complement policies that aim directly at closing productivity gaps between firms, including via the enhancement of skills and innovation capabilities of lagging firms (Nicoletti, von Rueden and Andrews, 2020[5]; Gal et al., 2019[6]). Promoting job mobility would reduce wage dispersion between firms at any given level of productivity dispersion while also raising the efficiency of labour allocation, and thereby productivity, average wages and employment.

The results further imply that particular care should be taken in reforming wage-setting institutions in countries where job mobility is low, such as a number of Southern European countries. In these countries, a closer alignment of productivity and wages through more decentralised collective bargaining would likely promote employment but may also raise wage dispersion between firms. The possible adverse effects on wage dispersion can be mitigated by combining sector-level bargaining with bargaining at the firm-level through so-called organised decentralisation rather than simply replacing sector-level by firm-level bargaining (OECD, 2019[7]). For example, sector-level agreements could include opt-out clauses or leave more scope for further negotiation at the firm-level. Another way of limiting possible adverse effects of decentralisation on wage dispersion would be to complement decentralisation with increases in, or the introduction of, statutory minimum wages where they are currently low or non-existent.

The remainder of the chapter is organised as follows. Section 3.2 provides a number of stylised facts on the dispersion of firm wage premia across countries, industries and regions. Section 3.3 proposes a conceptual framework to analyse the link between productivity and wages across firms and describes the empirical approach. Section 3.4 presents the results on firm-level productivity-wage pass-through, as well as the structural and policy factors shaping it. Section 3.5 concludes by drawing out the policy implications emerging from the empirical analysis.

In order to situate the analysis in this chapter in the overall context of this Volume, it is useful to resort to a simple decomposition (Figure 3.1). Overall wage inequality can be decomposed into a between-firm and within-firm element. Within-firm wage inequality is largely determined by differences in worker characteristics such as gender, skill and experience. The between-firm element can be decomposed further into differences in workforce composition, and differences in firm wage premia that are independent of workforce composition. Firm wage premia can be obtained by estimating average firm wages while netting out the effect of average workforce characteristics, such as gender, skill and experience (see in Chapter 2 for details). This chapter focuses on the link between productivity and firm wage premia, as well as the policies and structural factors shaping it, including competition in labour and product markets, as well as wage setting institutions.

Firm wage premia, i.e. the part of wages that is determined by firms rather than workers’ individual characteristics, are estimated using linked employer-employee data as in Chapter 2 by purging firms’ average wages from the individual characteristics of their workers, i.e. typically occupation, education, age, gender and working-time status.4 Using these estimated wage premia, Chapter 2 shows that in most countries, dispersion in firm wage premia accounts for around one-third of overall wage inequality.5

To analyse the role of productivity dispersion in wage dispersion between firms, this chapter focuses on wage premia differentials within industries. Wage premia differentials between industries are small relative to differentials between firms within the same industry.6 On average across countries, around 75% of dispersion in firm wage premia is explained by wage differences between firms within the same industry (Figure 3.2).7 The contribution of between-industry wage premia dispersion is likely to increase relative to the within-industry component when using more detailed industry disaggregations. For example, evidence for the United States suggests that at a higher level of industry disaggregation (4-digit instead of 2-digit) the contribution of the between-industry component may account for a significantly higher share of overall wage premia dispersion (Haltiwanger and Spletzer, 2020[8]).

Wage premia dispersion is typically larger in countries with larger productivity dispersion, suggesting that wage premia dispersion may at least partly be related to productivity dispersion (Figure 3.3). In labour markets with frictions that limit job mobility, firms partly pass on productivity differentials to wages of workers with similar characteristics. Higher-productivity firms need to offer higher wages to attract workers from lower-productivity firms which can, in turn, offer lower wages without losing all workers. In other words, higher productivity is partly reflected in higher wages and partly in higher employment.

A positive link between firm-level productivity and wage premia arises as the consequence of labour market frictions, but may also depend on competition in product markets as well as institutional features of the wage-setting process (Manning, 2020[3]).

In perfectly competitive labour markets where workers move from a job in one firm to a job in another one as soon as there are differences in wage premia between them (i.e. there are no barriers to job mobility) productivity differences translate into differences in employment without generating wage differences. Firms adjust employment until the marginal products of labour are equalised across them and wages equal the marginal products of labour. All firms pay identical wages, i.e. they are “wage-takers”, but high-productivity firms employ more workers than low-productivity ones. By contrast, in labour markets where job mobility is limited (i.e. labour supply to the firm is upward-sloping) productivity differences translate into differences in both employment and wages. High-productivity firms demand more labour than low-productivity ones but barriers to the mobility of workers prevent marginal products of labour from equalising across them. Irrespective of whether firms set wages equal to their respective marginal products of labour, or whether they exploit the wage-setting power stemming from the upward-sloping labour supply curve and set wages below marginal products, wages are higher in high-productivity firms.

Limited job mobility may reflect information frictions, pecuniary or non-pecuniary costs to job switching, or individual preferences for non-wage job characteristics (such as working conditions or commuting time). Models of labour market monopsony typically exploit one or a combination of these microeconomic drivers of limited job mobility to generate a surplus from a job match (“rent”) that firms may partially share with workers. The common mechanism underlying pass-through of productivity to wages in all of these models is an upward-sloping labour supply curve to the individual firm (Manning, 2020[3]).8 A flatter labour supply curve increases the average level of wages by limiting the scope for employers to mark down wages relative to marginal productivity, and reduces the link between productivity and wages between firms by limiting the dispersion of marginal labour productivity. In other words, higher productivity pass-through can be viewed as undesirable since it reflects barriers to job mobility and misallocation of labour across firms.

An alternative view, which does not rely on the wage-setting power of firms resulting from an upward-sloping labour supply curve, is that firms and workers bargain over the distribution of rents. In search and matching models with wage bargaining, workers and firms bargain over rents that arise from barriers to job mobility (Pissarides, 2000[9]). Importantly, these different models raise the question whether firm-level productivity-wage pass-through should be viewed as a symptom of low job mobility and a measure of misallocation of workers across firms, or as the potentially efficient sharing of rents between firms and workers (Box 3.1).9

Given the importance of labour market frictions, firm-level productivity-wage pass-through is expected to be large when labour market frictions are large, which is likely to be reflected in low rates of voluntary job mobility.10 To some extent, voluntary job mobility can be influenced by policies that reduce the cost of job switching for workers, including in the areas of occupational licensing and non-compete clauses; job-search assistance and training; as well as residential mobility and telework. A more competitive product market environment may also raise pass-through (Annex A). In such an environment, firms pass on a large share of productivity gains to product prices and gain a larger share of the market than in an environment with more limited product market competition, which induces a larger adjustment in employment and thus a larger adjustment in wages. Finally, pass-through will tend to be larger the more wage setting takes place at the firm-level (or worker level) rather than at the industry or national levels. Wage-setting institutions such as collectively agreed industry-level wage floors or national minimum wages may constrain firms’ wage-setting choices and thereby weaken the link between firm-level wages and productivity.

While productivity pass-through is partly determined by market-level variables such as job mobility, product market competition and wage institutions, it may vary even within the same firm. Such within-firm differences could reflect monopsonic wage discrimination as firms set lower wages for workers with fewer opportunities (e.g. women, low-skilled workers); differences in demand for different groups of workers across low- and high-productivity firms, e.g. due to complementarities between technology and skills; or differences in bargaining power.

Ideally, firm-level productivity-wage pass-through is analysed empirically using worker-level linked employer-employee data. The worker-level approach relates worker-level wages to firm-level productivity (see Box 3.2 for the technical details). Its main advantage is that it can provide granular insights into firm-level pass-through, including differences between different groups of workers such as low-skilled and high-skilled workers or men and women. Worker-level data can also be used to construct measures of local labour market concentration to analyse the extent to which the degree of productivity-wage pass-through depends on the number of potential employers. The drawback of the individual-level approach based on worker-level data is that it is only feasible where productivity is available in linked employer-employee data, which is currently only the case in nine of the countries for which data were collected for this study, making it difficult to systematically relate the degree of pass-through to industry and country characteristics.

In the absence of matched employer-employee data with information on productivity at the firm level for a large number of countries and the impossibility of pooling the worker level information across countries due to confidentiality issues, the analysis resorts to an industry-level approach to analyse the cross-industry and cross-country pattern of productivity-wage pass-through. The industry-level approach relates between-firm dispersion in wage premia within industries to between-firm dispersion in productivity. Its main advantage is that it can be applied to countries for which productivity is not available in the linked employer-employee data by computing between-firm dispersion in productivity from external data sources, namely representative firm-level data through the OECD MultiProd database (Berlingieri et al., 2017[11]). The significant variation across countries, industries and over time makes this approach ideal for analysing the structural and institutional determinants of firm-level productivity-wage pass-through. The industry-level empirical analysis is conducted on 13 OECD countries over the period 2001-15 and covers 22 industries for which high-quality data on productivity dispersion are available.

The empirical analysis considers structural and institutional characteristics that relate to job mobility, product market competition, as well as wage-setting institutions (Annex Table 3.B.1). Job mobility is proxied by the share of annual job-to-job transitions in total employment.11 The idea is that in a near perfectly competitive labour market without frictions the elasticity of labour supply is high, so that employed workers can be expected to voluntarily move between jobs as soon as they receive a job offer with a marginally higher wage. The advantage of the rate of job-to-job transitions as a measure of the elasticity of labour supply is that it is likely to exclude most involuntary job transitions, which typically involve transitions into non-employment. Product market competition is proxied by import competition (defined as the share of imported value added in domestic demand) which, in contrast to indicators of product market regulation, is available at the country-industry level of disaggregation, and is unlikely to be correlated with labour market competition. The role of collective bargaining is analysed by focusing on the level of decentralisation in collective bargaining systems, i.e. largely decentralised systems based on firm-level bargaining or more centralised systems with a stronger emphasis on sector or national level bargaining (OECD, 2019[7]).12 The minimum wage is expressed by the ratio of the statutory minimum wage to the median wage of full-time workers.

Using the industry-level approach, the elasticity of firm-level wage premia to productivity is estimated to be around 0.15 on average across countries (Figure 3.4). This is in the range of estimates of firm-level productivity-wage pass-through in previous research (Card et al., 2018[12]). The country-by-country estimates based on the individual-level approach suggest that there is significant variation in pass-through across countries, with the pass-through elasticity ranging from 0.08 in the Netherlands to 0.22 in Hungary. Thus the average estimate of productivity pass-through across countries is likely to depend on country composition.

Across firms within the same industry, productivity-wage pass-through tends to be higher for high-skilled workers than low-skilled workers and higher for men than women (Figure 3.5). Differences in pass-through across different groups of workers imply that productivity-wage pass-through affects both wage inequality between firms and inequality within them. With homogeneous pass-through across different groups of workers, larger productivity dispersion only raises between-firm wage inequality. It may additionally raise within-firm wage inequality if pass-through is larger for high-skilled workers and men who typically earn higher wages to begin with. In other words, larger pass-through for high-skilled workers and men provides an explanation for the empirical fact documented in Chapter 2 that within-firm and between-firm wage inequality tend to go together.

The role of labour market frictions is analysed by relating productivity-wage pass-through to (i) the share of job-to-job transitions in employment as a proxy of voluntary job mobility, or (ii) to local labour market concentration as a proxy of employers’ wage-setting power (monopsony). The results suggest that productivity-wage pass-through increases with the degree of labour market frictions as measured by a low rate of job-to-job transitions (Figure 3.6, Panel A). As workers do not easily move from one job to another, low-productivity employers can afford paying low wages relative to high-productivity ones. Conversely, high-productivity employers need to raise wages well above low-productivity ones to poach workers from them. The negative relation between job mobility and productivity pass-through is robust to the use of alternative measures of job mobility (Annex Table 3.B.3, Column 6), as well as to controlling for interactions of productivity with trade in value added and collective bargaining (Annex Table 3.B.2, Column 10).13 The effect of raising job mobility on overall wage inequality through the pass-through channel is quantitatively significant: raising job mobility from the average of countries with low job mobility to the average of those with high mobility – roughly equivalent to an increase from the 20th percentile of job mobility (Greece) to the 80th percentile (Sweden) – would reduce overall wage inequality by about 15%. To put this reduction in perspective, the median increase in wage inequality across countries over the period 1995-2015 was around 10% (see Chapter 2).14

The importance of job mobility for productivity pass-through is confirmed in a variety of sensitivity checks (Annex Table 3.B.3). A first issue with the rate of job-to-job transitions as a measure of job mobility is that it may be positively correlated with the business cycle so that it may pick up the effects of low unemployment rather than job-to-job mobility. However, while the estimated coefficient on the interaction between productivity and unemployment is indeed highly significant, the rate of job-to-job transitions continues to be negatively related to productivity pass-through (Annex Table 3.B.3, Column 2). Similarly, controlling for the employment rate does not significantly change the estimated pass-through coefficient (Annex Table 3.B.3, Column 3). Another issue with the rate of job-to-job transitions is that it may be endogenous to the wage structure. For a given level of productivity dispersion, a more compressed wage structure may reduce incentives for job-to-job mobility. To reduce the risk of endogeneity, an alternative mobility measure is constructed as the product of average job mobility in all other industries in the same country and average job mobility in the same industry in all other countries. The advantage of this measure is that it can reasonably be considered as exogenous to wage-setting in a specific industry and country. The negative relation between industry labour market frictions and productivity pass-through at the firm level is robust to using this transformed variable as an instrument (Annex Table 3.B.3, Column 5).15

Evidence from Portuguese LinkEED data with information on firm-productivity suggests that wages are lower and the degree of wage-productivity pass-through is generally higher in local labour markets where employment is highly concentrated in a small number of employers than elsewhere (Box 3.4). This is consistent with previous studies suggesting that local labour market concentration reduces the elasticity of labour supply as job opportunities in other firms decline (Azar, Marinescu and Steinbaum, 2019[16]). On average, as described in Figure 3.7, the empirical model suggests that wage premia are about 6% lower in firms in highly concentrated labour markets (i.e. at the 75th percentile of the distribution of local labour market concentration) than in less concentrated ones (i.e. those at the 25th percentile). Importantly, however, while wage premia appear to be lower, productivity-wage pass-through appears to be significantly larger in highly concentrated labour markets. The most productive firms pay about 55% higher wage premia than the least productive firms in highly concentrated labour markets. By comparison, in less concentrated labour markets, this pay difference is significantly lower at around 45%. This is likely to reflect the fact that when workers have limited job options outside of their current employer, as is the case in highly concentrated labour markets, low-productivity firms can afford paying lower wages relative to high-productivity ones and nonetheless attract (or retain) a sufficient number of workers. The results account for the role of unobserved factors that affect wages and local labour market concentration and are robust to different definitions of local labour market concentration. In future work of the OECD LinkEED project, this analysis will be extended to a number of other countries for which the necessary data are available.

Pass-through of productivity to wage premia is larger in industries that face stronger import competition as measured by the share of imported value added in final domestic demand (Figure 3.6, Panel B). In a competitive environment, a given change in productivity induces a larger adjustment in employment and thus a larger adjustment in wages, as firms passing on the productivity gain to product prices gain a larger share of the market than in an environment with limited product market competition. According to the empirical estimates, productivity pass-through at the firm-level is about 13 percentage points larger in countries and industries with an above-median share of imported value added in final domestic demand than in those with a below-median share (22% compared with 9%). Measures that proxy domestic competition, such as industry concentration, are generally not statistically significant, which could reflect the fact that stronger product market competition may also raise competition for workers, including through the market entry of new firms (Annex Table 3.B.2).16

The decentralisation of collective bargaining tends to increase the pass-through of firm-level productivity to wages (Figure 3.6, Panel C).17 Collective bargaining systems characterised by a predominance of industry-level bargaining (labelled “centralised”) focus on industry-wide productivity in wage setting, whereas systems based on a predominance of firm-level bargaining (labelled “fully or largely decentralised”) allow for larger differentiation of wages according to firm-specific productivity.18 Country-specific evidence on decentralisation of collective bargaining in Germany supports the cross-country evidence on the positive link between decentralisation and productivity-wage pass-through at the firm-level. In Germany, there has been a tendency towards more flexibility in wage setting at the firm-level over the past three decades, partly driven by the increased scope for within sector-level agreements in bargaining at the firm-level and partly by declining collective bargaining coverage, which has tended to raise the pass-through of firm-level productivity to wages (Box 3.5).

Statutory minimum wages (relative to the median wage) also tend to reduce productivity pass through at the firm-level (Figure 3.6, Panel C). A key argument for the use of minimum wage is to contain the wage-setting power of employers in imperfectly competitive labour markets and ensure fair wages for workers, particularly those with limited skills or a weak bargaining position.19 The results suggests that the impact of minimum wages on overall wage dispersion, as documented for example in OECD (2018[24]), is partly driven by a reduction in wage dispersion between firms for a given level of productivity dispersion. The compression of the wage distribution may have adverse effects on the efficiency of labour allocation but recent evidence for Germany and Israel suggests that this may not necessarily be the case. Higher minimum wages may force low-productivity firms to raise productivity or exit the market, thereby reducing productivity dispersion (Drucker, Mazirov and Neumark, 2019[25]; Dustmann et al., 2021[26]).

While wage differences between firms originating from productivity-wage pass-through provide incentives for workers to move from lower-productivity to higher-productivity firms, they also raise overall wage inequality (Criscuolo et al., 2020[27]). The results in this chapter suggest that the extent of firm-level productivity-wage pass-through is shaped by the degree of competition in labour and product markets, as well as the nature of wage-setting institutions. Conditional on productivity dispersion, wage dispersion between firms increases with frictions in the labour market and is amplified by strong product market competition and decentralised collective bargaining. The key policy question raised by these empirical results is how to promote productivity-enhancing reallocation without widening pay differences between firms, especially in a context of potentially large shifts in labour demand across firms and industries in the wake of the COVID-19 crisis.

The main policy implication emerging from this chapter is that facilitating voluntary job mobility of workers would not only raise productivity growth by easing reallocation from low to high-productivity firms but may also limit wage dispersion between firms by weakening the link with productivity dispersion. In the absence of complementary measures to facilitate job mobility and strengthen competition in labour markets, trade and competition-friendly product market reforms as well as the gradual decentralisation of collective bargaining in countries with a strong tradition of sector-level bargaining risk raising overall inequality by raising wage dispersion between firms. Policies that would facilitate job mobility and strengthen competition in labour markets include:

• Limiting legal and contractual barriers to job mobility can promote competition between employers for workers and strengthen worker incentives for taking up new opportunities. Opportunities for job mobility tend to be more limited in more concentrated local labour markets (Naidu, Posner and Weyl, 2018[28]; OECD, 2019[29]) and where the importance of non-compete clauses, no-poaching agreements, and occupational licensing requirements is greater (Bambalaite, Nicoletti and von Rueden, 2020[30]; Kleiner and Xu, 2020[31]; Lipsitz and Starr, 2019[32]).

• Strengthening adult learning and taking a more comprehensive approach to activation that goes beyond promoting access to employment would help workers find better jobs in other firms. For instance, public employment services in the form of job-search assistance, training and career counselling could be made available to workers in jobs that are supported by job retention schemes that were used on a massive scale in most OECD countries to curb job losses as a result of the COVID-19 crisis (OECD, 2020[33]; OECD, 2020[34]). More generally, public employment services could be made available to all workers who would like to progress in their careers but face significant barriers in moving to better jobs, including people in non-standard forms of work, as well as people who are currently employed but lack relevant skills or live in lagging regions. This would require a more active role of public employment services in advising workers on adult learning opportunities, as well as collecting information on skill requirements of prospective employers.

• Mobility across geographical areas could be fostered by reforming housing policies, including by redesigning land-use and planning policies that raise house price differences across locations, reducing transaction taxes on selling and buying a home, and relaxing overly strict rental regulations (Causa and Pichelmann, 2020[35]). Social cash and in-kind expenditure on housing could also support residential mobility by raising the affordability of housing for low-income households, especially if such expenditure is designed in such a way that benefits are fully portable across geographical areas.

• An expansion of telework could partly compensate for limited geographical mobility. A significant fraction of jobs can potentially be conducted remotely – between one-quarter and one-third of all jobs according to some estimates (Dingel and Neiman, 2020[36]; Boeri, Caiumi and Paccagnella, 2020[37]; OECD, 2020[38]) – potentially raising job opportunities for workers and reducing costs to move from one job to another. Promoting telework will require strengthening digital infrastructure to increase network access and speed for all workers as well as digital adoption by firms; enhancing workers’ ICT skills through training; as well as raising employers’ management capabilities through the diffusion of managerial best practices (Nicoletti, von Rueden and Andrews, 2020[5]; OECD, 2020[38]).

A significant degree of barriers to job mobility are likely to remain even after addressing policy distortions that contribute to labour market frictions. Workers differ in their preferences for jobs in different firms, industries and geographical areas as well as their ability to perform them, and firms differ in terms of non-wage working conditions and skill requirements, which creates inherent barriers to job mobility. Moreover, raising job mobility may not be the most effective policy to address within-firm wage inequality, which is likely to mainly reflect differences in individual worker characteristics such as skills or gender. Skills policies that allow all workers to acquire and update relevant skills over the life cycle and policies that raise women’s opportunities to work in high-productivity firms, including through flexible work schedules and telework, will need to complement policies to raise job mobility. Tax and benefit systems can also prevent workers who have limited job opportunities despite measures to promote mobility, skills and working time flexibility from experiencing poverty and financial hardship.

In principle, wage-setting institutions in the form of minimum wages and collective bargaining could help to contain the wage-setting power of firms in labour markets with limited job mobility, thereby reducing pay differences between them. In areas and occupations where wages are well below workers’ productivity, this could even raise employment by raising labour market participation among people who are unwilling to work at current wages. However, there is a risk that wage floors are set at levels in excess of workers’ productivity, which would reduce employment. This risk could be reduced by combining centralised collective bargaining with sufficient scope for further negotiation at the firm level, and focusing minimum wage increases on areas and groups for which initial levels of wages are low. Ongoing research based on a comparison between Norway and the United States further suggests that wage compression between firms does not necessarily reduce the efficiency of labour allocation between firms (Hijzen, Zwysen and Lillehagen, 2021[39]). The key to achieve high productivity through an efficient allocation of labour is to complement wage-setting institutions that constrain the ability of firms to pay different wages for similar workers with measures that promote innovation in low productivity firms and strengthen job mobility.

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In a perfectly competitive labour market, there are no frictions related to the costs of finding and changing jobs that limit workers’ job options outside of their firms. In such a setting, all firms pay the single market wage irrespective of their productivity since no worker would accept a lower wage and paying a higher wage would reduce firms’ profits. In formal terms, this implies that firms are price-takers in labour markets, with the labour supply curve being flat (“perfectly elastic”). Workers receive a wage equal to the market wage, which is in turn equal to workers’ marginal product. Importantly, the market wage is independent of the productivity of the firm for which they work.

In imperfectly competitive labour markets with frictions related to the cost of finding and changing jobs, or preferences over jobs’ non-wage characteristics, workers’ job options outside of their firms are limited. Consequently, not all workers quit when paid less than their marginal product and individual firms face an upward-sloping labour supply curve, which describes reservation wages of marginal workers (Annex Figure 3.A.1).20 Assuming that firms are unable to observe the outside options of individual workers (i.e. they cannot price discriminate between them), the cost of attracting additional workers (i.e. the marginal cost of labour) typically exceeds their reservation wage.21 Firms set wages so that labour supply to the firm corresponds to the profit-maximising employment levels, i.e. where the marginal revenue product of labour (MRP) and the marginal cost of labour (MCL) are the same.22

As productivity increases, at each level of employment the more productive firm is in principle willing to pay a higher wage (i.e. labour demand shifts outwards), since higher productivity allows it to absorb higher labour costs. Thus, firm-level wages co-move with productivity even for workers with identical earnings characteristics. Labour demand of the high-productivity firm (firm 1) is above that of the low-productivity firm (firm 0), resulting in a positive wage gap between the high-productivity and the low-productivity firm (w1 – w0). In other words, there is positive pass-through of productivity to wages at the firm level, leading to dispersion in wages that is proportional to productivity dispersion. By contrast, in perfectly competitive labour markets with perfectly elastic labour supply, firms have no wage-setting power and productivity dispersion does not translate into wage dispersion between firms.

The degree of productivity pass-through (i) declines with the elasticity of labour supply; (ii) increases with the elasticity of labour demand; and (iii) declines with the level of institutional wage floors (Annex A).

1. I. A decline in the elasticity of labour supply rotates the labour supply curve anti-clockwise, so that a given productivity difference between firms translates into a larger equilibrium wage difference. The elasticity of labour supply increases with job mobility, which is in turn partly determined by labour market frictions (Annex Figure 3.A.2, Panel A).

2. II. An increase in the labour demand elasticity rotates the labour demand curve anti-clockwise, so that a given productivity difference between firms – as measured by the vertical distance in the labour demand curve – translates into a larger difference in firm wage premia (Figure A.2., Panel B). The elasticity of labour demand increases with competition in product markets.

3. III. Collectively agreed wage floors at the industry level or statutory minimum wages may raise wages of low-productivity firms above their profit-maximising levels, which would reduce wage differences between firms at any given productivity difference.

A reduction in the elasticity of labour supply rotates the labour-supply curve anti-clockwise, giving rise to an upward-sloping labour-supply curve (Annex Figure 3.A.2, Panel A). The productivity difference between a less productive firm 0 and a more productive firm 1 – as reflected by the vertical distance between their labour demand curves, LD0 and LD1 – translates into a difference in firm wage premia (w1(B)-w0(B)). The pass-through of productivity to wages (and wage dispersion at any given level of productivity dispersion) declines with the elasticity of labour supply, i.e. the flatter the labour supply curve. At the same time, wages are marked down relative to marginal labour productivity, implying that workers earn less on average in the imperfectly competitive equilibrium than in the perfectly competitive one.

The elasticity of labour supply to the individual firm is partly determined by job mobility, which in turn depends, among other things, on local labour market concentration; the number of job vacancies per firm; hiring and firing costs (e.g. employment protection); the availability of easily accessible information on job opportunities (e.g. on-line platforms, public employment services); and regulatory barriers to mobility such as occupational licensing or distortions in the housing market (e.g. high taxes on housing transactions). In some cases, job mobility may also be held back by tacit agreements between firms not to hire workers from each other (no-poaching agreements) or contract clauses that prevent workers from moving to competing firms during a certain period (non-compete clauses).

An increase in the elasticity of labour demand rotates the labour-demand curve anti-clockwise, making the labour-demand curve flatter (Annex Figure 3.A.2, Panel B). The productivity difference between two firms, as reflected by the vertical distance in the labour demand curve, translates into a larger difference in firm wage premia the higher the elasticity of labour demand (w1(B)-w0 compared with w1(A)-w0). The wage-elasticity of labour demand increases with the price-elasticity of final demand (product market competition) and the elasticity of substitution between labour and other factors of production, such as capital or services (automation, outsourcing and offshoring).

A pro-competitive environment in product markets, which could for instance reflect domestic product market policies or trade policies, tends to raise the price-elasticity of final demand and thereby the wage-elasticity of labour demand. In such an environment, a change in productivity induces a larger response of output and employment at any given level of wages (a larger horizontal shift in labour demand). Given an upward sloping labour supply curve, wages need to adjust by more to accommodate the shift in labour demand.

Technology also shapes the transmission of productivity to wages, but is likely to be less relevant in practice. Automation and offshoring increase the ease with which labour can be substituted by capital or imported intermediate inputs and hence increases the sensitivity of firm employment to wages. In imperfectly competitive labour markets this has a tendency to mitigate the effects of productivity dispersion on wage dispersion by reducing the labour intensity of production in more productive firms. Given the second-order role of technology via this channel in the present framework this will not be analysed empirically.

Collectively agreed wage floors at the industry level or statutory minimum wages may raise wages of low-productivity firms above their profit-maximising levels (${w}^{0}$ in Annex Figure 3.A.1). This would reduce wage premia dispersion between firms at any given level of productivity dispersion, i.e. it would weaken the degree of firm-level productivity-wage pass-through. The co-ordination of collective bargaining outcomes across sectors by means of wage norms or wage ceilings would also tend to reduce wage premia differences but mainly between industries rather than between firms (OECD, 2019[7]). By contrast, the decentralisation of collective bargaining from the industry to the firm level is likely to increase firm-level productivity-wage pass-through with respect to either industry-level or national-level collective bargaining.

## Notes

← 1. This chapter has been written by an OECD team consisting of Chiara Criscuolo, Alexander Hijzen, Michael Koelle and Cyrille Schwellnus with contributions of: Erling Barth (Institute for Social Research Oslo, NORWAY), Wen-Hao Chen (Statcan, CANADA), Richard Fabling (independent, NEW ZEALAND), Priscilla Fialho (OECD, PORTUGAL), Alfred Garloff (IAB, GERMANY), Katarzyna Grabska-Romagosa (Maastricht University, THE NETHERLANDS), Ryo Kambayashi (Hitotsubashi University, JAPAN), Valerie Lankester and Catalina Sandoval (Central Bank of Costa Rica, COSTA RICA), Balazs Murakőzy (University of Liverpool, HUNGARY), Oskar Nordström Skans (Uppsala University, SWEDEN), Satu Nurmi (Statistics Finland/VATT, FINLAND), Balazs Stadler (OECD), Rudy Verlhac (OECD), Richard Upward (University of Nottingham, UNITED KINGDOM), and Wouter Zwysen (ETUI, formerly OECD). Orsetta Causa (OECD, ECO) kindly provided the job-to-job mobility data used in the empirical analysis. Rudy Verlhac (OECD, STI) helped with the access and the analysis based on the MultiProd data. For details on the data used in this chapter please see the standalone Data Annex and Disclaimer Annex.

← 2. Weakening the firm-level link between productivity and wage premia should not viewed as a policy objective per se but as the consequence of policies that reduce job-mobility reducing distortions in the economy.

← 3. To the extent that job mobility may have direct effects on productivity dispersion between firms, the overall downward effect of higher job mobility on wage inequality may be larger or smaller. It may be larger if higher job mobility forces low-productivity firms out of business but it may be smaller if increased sorting of high-skilled worker into high-technology firms raises productivity in the technologically most advanced firms.

← 4. In formal terms, firm premia are recovered as the estimated firm effects in the equation $\mathrm{ln}{w}_{ijt}={x}_{it}\beta +{z}_{jt}+{\epsilon }_{ijt}$, where ${w}_{ijt}$ denotes the wage of worker i in firm j at time t; ${x}_{it}$ denotes a vector of observable worker characteristics; β denotes the estimated return to these characteristics; denotes firm fixed effects of firm j in year t; and ${\epsilon }_{ijt}$ denotes the error term (Barth et al., 2016[41]).

← 5. Accounting for unobservable differences in workforce composition between firms slightly reduces the contribution of firm wage premia to the overall level of wage dispersion, but has no systematic impact on their contribution to changes in overall wage dispersion.

← 6. A large body of evidence has documented significant and persistent inter-industry wage differentials (Abowd et al., 2012[43]; Jean and Nicoletti, 2015[45]).

← 7. The role of regions appears to be even smaller. In the restricted number of countries where information on the location of the firm is available, dispersion in wage premia between regions contributes at most 10% to the within-industry dispersion of firm wage premia. In this sense, wage premia dispersion between firms does not simply reflect compensation for higher housing costs in dynamic urban areas.

← 8. This mechanism is illustrated in more detail using the simple static monopsony model in Annex A. In static and dynamic monopsony models, high-productivity firms unilaterally post high wages to attract workers who are imperfectly mobile. Wage setting in the static monopsony model is analysed in Robinson (1933[48]), Manning (2013[47]), Card et al. (2018[12]) and Lamadon et al. (2020), while analyses of the dynamic monopsony model include Burdett and Mortensen (1998[44]) and Manning (2011[42]). Another alternative micro-foundation for an upward-sloping labour supply curve are efficiency wage models in which the effective labour input that firms receive rises with the wage because higher-paid workers exert more effort (Manning, 1995[46]).

← 9. In the static monopsony model, wages of all firms are marked down by a constant factor relative to their marginal products of labour but firm-level wages are proportional to firm-level productivities.

← 10. Job mobility is also determined by worker preferences over non-wage characteristics of jobs (Manning, 2013[47]).

← 11. The measure is calculated at the country-industry level from the European Labour Force Survey over the period 2000-17 (Causa, Luu and Abendschein, 2021[40]).

← 12. The distinction between decentralised and more centralised collective bargaining systems in based on the OECD taxonomy of collective bargaining systems which consists of three main building blocks (OECD, 2019[7]): i) the level of bargaining at which collective agreements are negotiated (e.g. firm level, sector level or even national level); ii) the role of wage co-ordination between sector-level (or firm-level) agreements to take account of macroeconomic conditions; iii) the degree of flexibility for firms to modify the terms set by higher-level agreements.

← 13. The results are qualitatively unchanged when using a measure of job-to-job mobility that accounts for transitions from other industries in addition to within-industry transitions.

← 14. Average pass-through when job mobility is low is 25% versus 7% when job mobility is high (Figure 3.6). At the median value of productivity dispersion (corresponding to France for where the variance of log productivity was 0.68 in the last year) this translates into a 0.037 log-point difference in overall wage variance, which is about 15% of the median overall wage variance across countries in the last available year. The average annual rate of job-to-job transitions is about 5.8% when job mobility is low (roughly corresponding to the value for Greece, Annex Figure 3.B.1), while it is around 10% when job mobility is high (roughly corresponding to the value for Sweden).

← 15. The negative relation between job mobility and pass-through is also robust to a more flexible fixed effects structure (Annex Table 3.B.5) and replacing discrete explanatory variables with continuous variables (Annex Table 3.B.4).

← 16. A complementary explanation may be that measures of industry concentration may not be meaningful indicators of competitive pressures in highly globalised economies, especially in manufacturing industries. Additionally, industry concentration could partly reflect large economies of scale or scope that do not necessarily imply a lack of product market competition so long as market entry is contestable. Unreported results suggest that more competition-friendly product market regulation reduces pass-through, but product market regulation indicators are not available at the country-industry level, and the effect on pass-through is thus identified through cross-country variation and variation over time only.

← 17. The associations are effectively based on comparisons of the average degree of productivity pass-through within sectors across groups of countries with different collective bargaining systems. Since collective bargaining systems tend to be deeply embedded in a countries’ broader institutional set-up, it is difficult to isolate the impact of specific collective bargaining systems in the present framework.

← 18. For the purposes of the econometric analysis underlying Figure 3.6, “centralised” and “organised decentralised” collective bargaining systems are grouped together. Centralised countries include France, Italy and Portugal; organised decentralised countries include Austria, Germany, the Netherlands, Norway and Sweden, and largely or fully decentralised countries include Canada, Costa Rica, Hungary, Japan and New Zealand.

← 19. The use of minimum wages has also been justified based on arguments i) to promote work incentives by making work pay; ii) boost tax revenue and/or tax compliance by limiting the scope of wage under-reporting; and iii) anchoring wage bargaining.

← 20. Firm-level and aggregate labour elasticities are fundamentally different concepts. Firm-level elasticities capture the degree of competition between firms for workers (or opportunities of workers outside of the firm) whereas aggregate elasticities capture the decision to participate in the labour market.

← 21. The inability or unwillingness of firms to price discriminate between workers implies that existing workers are paid the same wage as newly hired workers. This means that labour costs increase more quickly when expanding employment than is suggested by the labour supply curve. If firms could perfectly observe workers’ reservation wages, the marginal cost of labour and the labour supply curve would coincide.

← 22. Note that the wage set by the firm is below the marginal revenue product of labour (i.e. wages are “marked down”) in inverse proportion to the elasticity of labour supply to the firm. If firms could perfectly observe workers’ reservation wages, equilibrium wages would be equal to the marginal revenue product of labour but, since marginal revenue products are not equalised across firms, wages would nonetheless be proportional to the firm’s average productivity. In other words, firm-level productivity-wage pass-through does not hinge on the assumption of unobservable reservation wages and marked down wages, but on an upward sloping labour supply curve.