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Disentangling the wage-productivity relationship: evidence from select OECD member countries.

Article Excerpt
Abstract

Conventional theory proposes that firms reward productivity improvements with higher wages. Conversely, efficiency wage theory suggests that wages can induce greater productivity. This paper applies a statistical technique that disentangles the potential bidirectional feedback between wages and productivity. Wage strategies in six industrialized countries with various labor market institutions are examined. Conventional and efficiency wage practices vary systematically across the industrialized countries; these variations are consistent with the expected effects of labor market institutions. (JEL J3, J4, J5)

Introduction and Review

The nature of the wage setting process is ambiguous. Do firms respond to labor productivity improvements with wage rewards or do they take a more active role in stimulating productivity improvements by paying relatively high wages? Conventional theory suggests that firms hire labor up to the point that the marginal product of labor equals the real wage. If workers become more productive, then firms will respond with wage rewards. Efficiency wage theory, on the other hand, proposes that high wage payments provide an incentive for workers to increase their productivity. An inherent problem with testing these theories is distinguishing the direction of the causal relationships between wages and productivity.

Cappelli and Chauvin [1991, p. 770] note that, "it is also difficult econometrically to avoid the identification problem: are higher wages the cause or the result of greater worker productivity?" One solution is to circumvent the question of causality by examining specific models, such as Salop's [1979] turnover cost model. For example, Campbell [1993] tests the model's assertion that workers who earn relatively high wages will be reluctant to quit or risk being fired. He finds that higher turnover costs are associated with higher wages and that higher wages are inversely related to quit rates in the U.S., as predicted by the model. (1) Most of the empirical support of efficiency wage behavior examines corollaries to specific efficiency wage models. (2)

In a critique of efficiency wage studies, Carmichael [1990] notes that the analyses of pay and productivity relationships must distinguish between conventional productivity-driven wages and efficiency wage behavior. This study identifies the relative roles of conventional and efficiency wage behaviors by applying Geweke's [1982; 1984] feedback technique that separates the linear relationship between two variables into bidirectional components, while separately identifying any contemporaneous association. Feedback from productivity to wages indicates conventional wage behavior; wage to productivity measures identify efficiency wage behavior. Geweke's directional feedback measures are an extension of Granger's [1969] definition of causality, but the contemporaneous component is unique to Geweke's technique.

Implementation

By focusing on worker behavior or using firm-level analysis several studies have confirmed that firms use efficiency wages to boost productivity. (3) Presumably, the institutional arrangements of the markets in which firms operate will influence their wage-setting strategies. Millea and Fuess [2002] consider the influence of output market characteristics on wage-setting strategies by comparing wage and productivity interactions across industrial sectors in Japan. They find that efficiency wage behavior is more prevalent in the relatively competitive, open industries, compared to regulated and protected industries. This study considers the influence of labor market characteristics on wage-setting practices by comparing the wage and productivity feedbacks of several industrialized countries with various labor market institutions.

The Bureau of Labor Statistics (BLS) reports real hourly compensation and real output per hour for several of the Organization for Economic Cooperation and Development (OECD) countries. (4) The OECD countries included in this study are Canada, France, Italy, Sweden, the UK, and the U.S., which represent a variety of labor market institutions that might influence wage-productivity interaction. In particular, the wage strategies are considered in terms of the market power of workers and employers (union coverage and the level of employer coordination) and in terms of unemployment assistance programs (generosity of benefits and retraining programs).

In the European countries, union contracts cover over 75 percent of the workers (see the first column of Table 1). (5) Presumably labor unions can improve workers' bargaining position, and thus increase firms' responsiveness to productivity gains, thus unions may enhance conventional wage practices.

Employers can also improve...

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