Efficiency Wages and Firm Size: An Analysis of Wage Differentials in Brazil, Lecture notes of Economics

Download Efficiency Wages and Firm Size: An Analysis of Wage Differentials in Brazil and more Lecture notes Economics in PDF only on Docsity! Estud. Econ., São Paulo, vol. 44, n.1, p.45-67, jan.-mar. 2014 ISSN 0101-4161 Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country Tatiane Almeida de Menezes Professora - Universidade Federal de Pernambuco (UFPE) Endereço: Av. dos Economistas, s/n - Cidade Universitária - Recife - Brasil CEP: 50670-901 - E-mail: tatianedemenezes@gmail.com Isabel Pessoa de Arruda Raposo Pesquisadora - Fundação Joaquim Nabuco Endereço: Rua Dois Irmãos, 92 - Apipucos - Recife - Brasil CEP: 52071-440 E-mail: isabel.raposo@fundaj.gov.br Recebido em 11 de janeiro de 2012. Aceito em 09 de outubro de 2013. Abstract Using data from the Brazilian Labor Monthly Survey (PME/ IBGE) for the years of 2006 and 2007, the paper investigates if the wage differential by firm size in Brazil can be explained by the predictions of the Efficiency Wage Theory. It is adopted a Switching Regression Model to estimate if large size companies pay a higher wage premium for dispended labor effort, as compared to smaller enterprises. The results prove the EW predictions since they evidence positive relationships between wages and labor effort, schooling and longer job duration. However, such findings are not sufficient to explain the existence of wage differentials by firm size in the Brazilian labor market. Keywords efficiency wage, labor effort, firm size, wage differentials Resumo Usando dados da Pesquisa Mensal de Emprego (PME/ IBGE) para os anos de 2006 e 2007, este artigo investiga se a diferença de salários por tamanho de firma no Brasil pode ser explicada pela Teoria do Salário Eficiência. Estimações de Switching Regression são utilizadas para verificar se as empresas de grande porte pagam um prêmio salarial maior aos seus funcionários por esforço despendido, comparativamente às pequenas empresas. Os resultados corroboram as predições do Salário Eficiência, uma vez que revelam uma relação positiva entre salário e esforço laboral e também entre escolari- dade e duração no posto de trabalho. No entanto, esses resultados não são suficientes para explicar o diferencial de salários existente entre grandes e pequenas empresas no mercado de trabalho brasileiro. Palavras-Chave salário eficiência, esforço laboral, tamanho da firma, diferenciais de salário Classificação JEL J01, J31 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 46 Tatiane Almeida de Menezes e Isabel Pessoa de Arruda Raposo 1. Introduction Empirical evidences demonstrate that different size enterprises pay different wages (Ahn, 2006; Fox, 2004; Arbache, 2001; Winter- Ebmer and Zweimüller, 1999; Romanguera, 1991; Brown and Medoff, 1989; US Department of Commerce Bureau of the Census, 1988, 1988; Barth et al., 1987). Most of them provide two sources of explanations. From one side, wage differentials by firm size arise because of firm and worker’s heterogeneity, and from the other side, companies with high monitoring costs pay higher salaries than the market clearing level (the Efficiency Wage Theory). In this paper we are particularly interested in verifying if the prediction of the EW theory, on its shirking version, can explain the wage differentials among different size firms in Brazil. According to competitive theories, the occurrence of wage disper- sion for similar workers would be basically a consequence of mea- surement problems in empirical estimations. Features that are not directly captured in the datasets, such as individual ś ability or non- pecuniary worker preferences, cannot be incorporated in wage de- termination models. For quite different mechanisms, the Efficiency Wage (EW) theory demonstrates how a wage distribution (for similar workers) can arise in equilibrium. The EW models incorporates the idea that enter- prises would get better economic results if they remunerate their employees with a higher wage than the market clearing level and there are various reasons why the firms would behave in such a way. In the shirking version proposed by Shapiro and Stiglitz (1984), firms that face high monitoring costs, such as the large companies, find shirking so costly that the payment of high wages is a proper incentive to extract labor effort. The existence of efficiency wage is supported by large empirical evidences (Rebitzer, 1995; Groshen and Krueger, 1990; Krueger and Summers, 1987 and 1988; Dickens and Katz 1987a and 1987b, and Groshen, 1986). In Brazil, it is worth mentioning three references. The work of Arbache (2001) found that unmeasured abilities and efficiency wage models played a role in the inter-industrial wage differentials for the decades of 1980s and 1990s. He estimated a significant and positive correlation between firm size and wage Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country 49 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 lists seven distinct approaches for the EW models, which will be briefly described below: • Nutritional Model: the earliest of these models. It was deve- loped by Leibenstein (1957) and established that the positive correlation between effort and wage would be motivated by the worker’s health and nutrition that could be achieved by highest consumption supported by higher salaries. • Adverse Selection Model: predicts that better workers have better alternative offers and that the high wage firms in- crease the probability of attracting a better pool of applicants (Weiss, 1980, apud Romanguera, 1991). • Recruiting Model: emphasizes that firms find costly to have a job offer turned down because of recruitment costs and for- gone production, therefore the entrepreneur has an incentive to catch the applicant by offering an elevated salary (Lang, 1988 and Montgomery, 1988, apud Romanguera, 1991). • Sociological or Normative Model: relies on the idea that agents are not completely individualistic in their choices, but also value social conventions that are not totally individualis- tic. As a consequence, the worker perceives his or her higher remuneration as a “gift” to be rewarded with more dedication to the job (Solow, 1979 and 1980; Akerlof, 1982 and 1984; and Akerlof and Yellen, 1988, apud Romanguera, 1991). • Union Threat Model: argues that collective action enables workers with bargaining power that allows them to appro- priate part of the firm’s rents, which in turn leads to higher wages (Dickens, 1986 apud Romanguera, 1991). • Turnover Model: it is very similar to the shirking version that will be presented next. This model assumes that labor turn- over is costly for the firm because they lose the investments made on the job training and because workers have lower productivity in the adjustment process. As a result, firms in order to minimize such costs have incentive to prevent turn- over by paying higher salaries (Salop, 1979 and Stiglitz, 1974, 1985 apud Romanguera, 1991). • The shirking version: it was proposed by Shapiro and Stiglitz (1984) and bases its structure on the following intuition: if unemployment represents a penalty for those who were caught shirking, then workers will choose not do so. The employers, on their side, in order to avoid shirking have in- Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 50 Tatiane Almeida de Menezes e Isabel Pessoa de Arruda Raposo centive to pay more than the “going wage”, thus if all firms act similarly the labor demand will reduce and, therefore, unemployment arises. Note that the employers cannot moni- tor the activities of their employees costlessly and perfectly and that is why high wage represents savings for the firm both in monitoring costs and in the increased output due to higher effort. Therefore, there is an informational problem between employers and workers in the structure of this mo- del that explains how involuntary unemployment can persist as an equilibrium phenomenon. The Basic Model of the Shirking Version (Shapiro and Stiglitz, 1984) The model starts assuming that there are a fixed number of N identical workers who dislikes exerting labor effort and enjoy con- sumption, with utility represented by U(w,e), where w is the wage earned and e is the level of effort put on the job activities. When an individual is unemployed, he or she receives a benefit of wb and e=0. There is a probability b, taken as exogenous, that a worker can be dismissed from the job due to relocation, for example, but not because he or she was caught shirking. However, if the employee shirks, there is some probability q that he or she will be caught and fired. The worker utility is maximized at a discount rate of r > 02. The only choice the worker makes is the selection of the effort level, by comparing the utility of shirking ( S EV ) and not shirking ( N EV ). The utility equations of a shirker and nonshirker are given by: )( S Eu S E VVqbw −++= (1) )( N Eu N E VVbew −+−= (2) where Vu is the utility of being unemployed that will be presented latter. Working with both equations yields the following solutions: qbr VqbwV uS E ++ ++ = )( (3) 2 When r is higher, the relatively more weight is attached to the short-run gains from shirking, until one is caught, compared to the losses incurred when one is eventually caught. Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country 51 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 br ewV uN E + +− = )( (4) The worker will not shirk if and only if S E N E VV ≥ , which produces the no-shirking condition (NSC): (5) Note that the critical wage is positively related with the effort level (e), the utility of being unemployed ( uV ), the interest rate (r) and with the quit rate (b), but it is inversely related with the proba- bility of being caught (q). From the employer’s side, the firm has a production function Qi = f(Li, Si), where L is the labor input and S is the supervisory in- put. An enterprise pays s for its supervisors and w for its employees and must pay some level wb of unemployment benefits, which will be set at the minimum level as possible. The idea behind the EW theory is that companies might differ on their monitoring techno- logy and, as a result, some will have incentive to pay more than the going wage. In order to find the no-shirking condition after incorporating the firm’s behavior, lets first present the utility of a worker being unemployed: )( uE b u VVaw −+= (6) where a is the job acquisition rate and EV is utility of an employed worker, which equals to N EV , in equilibrium. Solving for (4) and (6), we have: (7) Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 54 Tatiane Almeida de Menezes e Isabel Pessoa de Arruda Raposo on employee’s recruitment, screening or training, variables that do not use to be registered on datasets. Worker’s unmeasurable attributes also poses challenges for the em- pirical testing of EW models. As an example, different individual’s ability cannot be controlled in cross section estimations. Besides, there is still the fact that the individuals might self-select them- selves into specific companies since they might have non-pecuniary preferences for small firms. Some workers judge that large enter- prises have a poor work environment because it has more rules, requests more intensive work or is more impersonal, thus, on the margin the employees have lower preferences for the big firms and the large employers need to pay a compensating wage to attract labor (Fox, 2004; Oi, 1983). Another commonly used proxy for detecting labor effort is the firm size. In this case, the idea is that it would be harder to monitor a great amount of employees and the payment of higher wages would stimulate workers to devote more effort that could substitute the supervisory input. However, the use of firm size as a proxy for work dedication is also a problematic variable, because it might be the case that other factors, like the mentioned non-wage preferences for small firms, would be contributing for a positive relationship between wages and firm size. Considering these endogeneity problems, direct OLS estimations of supervision (or firm size) on salaries would produce biased estimates for the referred effort proxies. Many authors tried to overcome such issues by proposing original solutions. Groshen and Krueger (1990) found an exogenous variable for supervision intensity in the American health sector: the amount of supervisory nurse that is regulated by law and, therefore, is not on the firm’s control. Rebitzer (1995) tested the EW hypothesis for contract workers in the petro- chemical industry and found a cleaner relationship between wages and supervision because there are specific institutional features surrounding the employment of such workers that guarantees the exogeneity of the monitoring variables. Esteves (2006) adopted the average job duration of supervisor workers for the Brazilian labor market, as an instrumental variable in a two-stage OLS estimation. Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country 55 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 3.2 Empirical Model In this section we present the empirical strategy used to investigate the inter-dependence of wage and firm size given worker and firm’s attributes. The hypothesis to be tested is that larger firms remune- rate better the worker effort because it might be a proper strategy to minimize monitoring costs which are greater in bigger companies. In order to investigate such question, this paper departs from the assumption that the decision of being employed can be seen as a two-part decision problem, where firstly the worker decides if she (or he) wants to work in a small or in a large firm and secondly her (or his) wage is determined. This assumption is based in Roy (1951), who considered that the existence of individual heterogeneous skills and self-selection into job occupations could create occupational dif- ferentials of earnings. The application of the Roy Model is very suitable for the problem studied in the present paper, since it might be the case that the wage differentials by firm size could arise as a consequence of he- terogeneous skills and levels of effort. According to Cameron and Trivedi (2005), the prototypical Roy model adapted to our problem is defined as follows. There is a latent variable * 1y indicating if the observed result is * 2y or * 3y , such as: 0 0 0 1 * 1 * 1 1 ≤ > = i i i y y iff iff y (12) where 0* 1 >iy if the individual i works for small firm in 2006 and 0* 1 ≤iy if he or she works for medium or large companies. Based in (12) it can be defined a linear system with additive errors for the latent variable: (13) Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 56 Tatiane Almeida de Menezes e Isabel Pessoa de Arruda Raposo The first equation indicates if the person works or not in a small firm. The second and third equations have as dependent variable the growth of the natural logarithm of wage, between 2006 and 2007, for the individuals who work in small and large firms: , respectively. The vector is composed of exogenous variables that represent the preferences and characteristics of individuals and mar- ket, while is a vector of instruments. The idea behind the system present in (13) is that αββ += 2 ' 23 ' 3 ii xx , where  is the extra-wage paid by larger enterprises for workers alike. Assuming that the corre- lated errors have a joint normal distribution, the simplest parametric model is given by: 23 23~ (14) As usual (14) is normalized for 12 1 =σ . The most common esti- mation strategy is the Heckman’s two-step method applied to the truncated means: (15) where )()()( 1 ' 11 ' 11 ' 1 ββφβλ iii zzz Φ= is the inverse-Mills ratio. At the first stage, it is estimated a probit model, which binary dependent variable ( * 1y ) is whether the individual works or not in a small enter- prise. This first-stage estimation is, thus, the selection equation and yields estimates of 1β and )( 1 ' 1 βλ iz . At the second stage, two separated OLS regressions give the estimates for and 133 . Maddala (1983) provides further details for this model and calls it Switching Regression Model. An important comment is that the OLS regression of on alone leads to inconsistent estimates of 2 and 3. It happens because the errors are correlated as the workers self select themselves into firms according to specific features such as the size. This, in turn, affects the wage determination. Therefore, the use of the switching Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country 59 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 Table 1 - Sample characteristic according to the firm size CHARACTERISTICS FIRM SIZE SMALL MEDIUM AND LARGE Individuals Man 59.64% 62.47% 16 to 25 years old 30.94% 23.29% 26 to 40 years old 40.90% 44.84% 41 to 70 years old 28.16% 31.87% Head of family 43.35% 48.93% Years of school 3.07 3.40 From the job Average wage R$ 602.66 R$1,593.62 Temporary contract 3.94% 4.65% Social security contribution 52.94% 84.64% Working for 1 month 1.63% 0.80% 1 month to 1 year of work 22.11% 17.25% 1 to 2 years of work 15.74% 13.88% Working for more than 2 years 60.52% 68.07% Sub-occupied 3.31% 2.13% Sub-remunerated 26.74% 8.62% Industry 12.41% 25.20% Construction 8.04% 4.47% Sales 32.12% 16.60% Financial 20.56% 20.21% Public administration 7.26% 15.44% N° of observations 6,196 30,828 Source: Labor Monthly Survey (Pesquisa Mensal de Emprego, PME/IBGE, 2006 and 2007). Table 1 tells us that there exists some worker heterogeneity from individual and, especially, from the job aspects. Medium to large size firms employ in average a higher percentage of man, head of family and hire employees slightly more educated. The greatest difference arise in terms of the wage paid: the average salary of large firms is almost three times as greater as the one paid in small and medium enterprises. Another striking discrepancy is the social security contribution and sub-remuneration. The highest percentage of workers under sub- remuneration helps to explain why the average wage of small firms is so much lower than the one paid in larger ones. Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 60 Tatiane Almeida de Menezes e Isabel Pessoa de Arruda Raposo The social security contribution, on its turn, is also expected to be inferior in small companies, since this segment of the Brazilian labor market concentrates the highest amount of the so-called “informal” business that do not pay taxes and usual legal labor costs. Other differences important to mention, but not as remarkable as the ones just cited, refer to the labor duration and the percentage of sub-occupied workers. In average 23.74% of the labor force employed in small firms has been working for less than 1 year, against 18.05% in bigger enterprises. The percentage of sub-occupied workers is higher in small firms, as well. The distribution among economic sector is also heterogeneous by firm size: medium to large size fir- ms concentrate labor demand on the industry segment, while small companies employ more on the sales sector 5. The Results for the Wage Growth Estimation in Brazil using Switching Regression Model In this section, the key hypothesis of this paper is tested. The switching regression model is used to investigate if the predictions of the efficiency wage theory holds for Brazil. The idea is to test if large firms because of higher monitoring costs do pay a higher wage in order to extract more labor effort. As already discussed, individuals might self select themselves into specific companies according to non-wage preferences for the firm and heterogeneous abilities. The assumption is that this choice is associated to some demographic and occupational characteristics, such as the variables presented in the selection equation in Table 2. The results in Table 2 indicate that the probability of working in a small size enterprise decreases with age, years of school, growth of schooling and within workers who are head of family. These results are consistent with empirical evidences provided by Fox (2004), in which he argues that it is efficient to match high-ability workers together with large employers because the marginal product of a manager supervising a large firm is greater. Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country 61 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 Additionally, older workers or heads of family represent individu- als carrying more familiar responsibilities, so they tend to be more experienced, value more the employment and, as consequence, are rather desired by more structured and large firms. On the other hand, the chances of working on a small size enterprise increase within workers under temporary contract and who contri- butes for social security. For the first case, Booth et al (2000) find evidences that temporary employees present greater probability of wishing to separate (either to change occupation or geographical lo- cation) or have a higher cost (or lower benefit) in acquiring specific human capital. Considering that large size firms tend to invest more on firm-specific training in order to produce large standardized vo- lumes of output, labor turnover can represent substantial cost for the large employer, therefore, they do not wish a worker who presents high probability of quitting. As for the positive relation between the chances of working in a small company and social security contribution, we have an unex- pected result, which is possibly associated with the recent “forma- lization” process in the Brazilian labor market that might be increa- sing the chances of a worker who benefits from social security to be employed in a small firm. In fact between 2006 and 2007, the proportion of employees who contributed to social security in small firms increased 10%, while the growth observed in large firms was only of 3% (PME/ IBGE, 2006 and 2007). The geographic dummies indicate that the probability of working in a small firm decreases in the metropolitan regions of Belo Horizonte, São Paulo and Porto Alegre relatively to the reference dummy of Salvador. This is an expected result since these three cities are lo- cated in the most developed regions of Brazil, which concentrate larger and more structured companies, while Salvador is located in a poorer region. Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 64 Tatiane Almeida de Menezes e Isabel Pessoa de Arruda Raposo sults derived from the EW theory. From one side, employers have incentive to pay more than the market-clearing wage in order to attract more productive and skilled labor, expecting to minimize the monitoring costs, and from the other side, the greater is the emplo- yee’s fidelity to the firms, the less expenses the enterprise will face with labor turnover. We already argued that the monitoring costs and labor turnover the firms use to face represent proper incentives to induce firms to attract more qualified labor and individuals who would rather not shrink because the penalty for losing their jobs would be long spells of unemployment and the lost of the elevated salary. Table 3 - Estimation for the wage growth between 2006 and 2007 by firm size VARIABLES SMALL MEDIUM AND LARGE COEF. STAND. ERR COEF. STAND. ERR School variation 0.2568*** 0.0133 0.2868*** 0.0062 Age -0.0174*** 0.0016 -0.0184*** 0.0008 Man -0.2582*** 0.0352 -0.2215*** 0.0167 Sub-occupied 0.3209*** 0.1054 0.3424*** 0.0497 Sub-remunerated 0.5566*** 0.0529 0.6122*** 0.0251 Social security contribution -0.2400*** 0.0416 -0.1284*** 0.0197 Working for 1 month 0.2829* 0.1455 0.1742** 0.0676 1 month to 1 year of work 0.2087*** 0.0423 0.2115*** 0.0203 1 to 2 years of work 0.1405*** 0.0499 0.1828*** 0.0240 Industry -0.1263** 0.0507 -0.1055*** 0.0243 Construction -0.0407 0.0805 -0.0525 0.0389 Sales 0.0439 0.0521 0.0733** 0.0253 Financial -0.0731 0.0521 -0.0557** 0.0250 Public administration 0.0538 0.0588 0.0443 0.0280 Recife -0.0431 0.0741 -0.1203** 0.0378 Belo Horizonte 0.3193*** 0.0636 0.2293*** 0.0316 Rio de Janeiro 0.3123*** 0.0596 0.1994*** 0.0304 São Paulo 0.6418*** 0.0629 0.4911*** 0.0302 Porto Alegre 0.5149*** 0.0662 0.3106*** 0.0324 Constant 1.5439*** 0.1299 0.4355*** 0.0469 Bold coefficients for p-value: ***p<0.01, **p<0.05, *p<0.1. Wage Differentials by Firm Size: The Efficiency Wage Test in a Developing Country 65 Estud. Econ., São Paulo, vol. 44, n.1, p. 45-67, jan.-mar. 2014 6. Conclusions The goal of this paper was to study if the wage differential between small and medium to large size firms in Brazil could be explained by the predictions of the EW theory, emphasizing the role of dispen- ded labor effort and the wage premium. Using data from the Labor Monthly Survey (PME/ IBGE) for the years of 2006 and 2007, the following hypothesis was tested: large size firms pay higher wages because they tend to remunerate better the effort in order to mini- mize monitoring costs, which are greater when compared to smaller enterprises. On such investigation we adopted empirical strategies based on a Switching Regression Model. On the first stage, probit estimations characterized the chances of working or not in a small size firm. Given the possible role of endogeneity involved in such decision of working or not in small firms, simultaneous equations models were estimated in order to incorporate the mentioned choice. These mo- dels were used to estimate the wage growth between 2006 and 2007 for the two groups of firms studied: small and medium/ large. The obtained estimates corroborated the idea that the dedication to labor effort had a positive impact on the wage. Furthermore, the growth of schooling and the longer permanence of the worker on the firm were also directly related with the increase of wage. These results were largely favorable to the predictions of the EW theory on its shirking version; however, they were not sufficient to explain the existence of wage differentials in the Brazilian labor market. References Ahn, Joyup. 2006. Nonstandard Work in Japan and Korea-the Origin of Wage Differentials. Unpublished manuscript, Japan Institute for Labor Policy and Training, Tokyo. Arbache, Jorge S. 2001. 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