Labor and Inequality

Overview: The Stylized Facts

It's now time to talk about income, something that gets people's attention.  Experience has shown that money matters and people's income are likely to be determined in large part by what happens in the labor market, so it is a natural to look more closely at what happens in the labor market.  In this unit we are going to try to make sense of the important developments in earnings, to explain what has been happening to earnings in this country, and to peer into the future to see where things are going when you graduate and enter that "real world" labor market. 

What is it that we need to explain?  What are the "stylized facts" of the labor market?  The two features of earnings we are going to focus our attention on in this unit are the level and distribution of earnings.  As you will see, things have been happening on both dimensions. 

To better understand what it is we are talking about in this unit, think about the problem of explaining income differences at RIU.  One place to look would be the income people earn from financial investments they have made.  Some could have had verrry good years in 1997 because they were well invested in the US stock market, while some got "hammered" in 1998 because of their investments in Asian markets.  While this is an important potential source of income differences, we could go beyond that and focus our attention only on earnings.  How much of a gap is there between what the university president gets paid and the secretary working in the Economics Department?  What about the difference between the earnings of a cook in the residence halls and a full professor in the English department?  We'll also look into an issue that never fails to provoke discussion - the differences in the earnings of males and females.

First, however, we will examine some international income data to gain some perspective on the situation in the US.  As the globalization process continues and our lives continue to become more inextricably linked to those in other countries, it is essential to have a sense of what is happening outside of the US.  Given that we are moving relentlessly toward a global society, any discussion of inequality in the US must be put in the context of world inequality.  This will be followed by a brief discussion of income inequality in the US which will provide the backdrop for a more thorough treatment of earnings in the labor market.  This will lead to a discussion of four determinants of earnings differentials, compensating differentials, ability and skills, imperfect competition, and discrimination and the factors that have contributed to the growing inequality.

No one will be surprised to find that income is inequitably distributed in the US and that poverty persists despite the policies designed to eliminate it.  Where you will find disagreement is on the extent of the inequality and poverty, the source of these problems, and the solutions.  If we take the long view, according to Prichett (1997), we are in the midst of a substantial widening of the gap between the 'haves' and the 'have nots ' and "divergence in relative productivity levels and living standards is the dominant feature of modern economic history."  Between 1870 and 1990 Prichett estimates the "ratio of per capita incomes between the richest and the poorest countries increased by roughly a factor of five ... ."  This was the result of relatively high rates of growth among the "advanced capitalist" or "high income OECD."  While there may have been some evidence of convergence among the "developed, advanced capitalist" countries, there are few instances where the "less developed" countries have not fallen further behind.  There is little evidence of any catching-up effect and considerable evidence that countries become caught in poverty traps.

When taking a shorter perspective, Jones (1997) finds that divergence is not the dominant characteristic of growth and that when we project recent patterns forward income inequality declines.  The convergence, however, is far from universal.  What he seems to find is that a number of countries in the middle of the income distribution have managed to increase their growth relative to the US, while many that were among the poorest have seen their relative growth decline since 1960.  As for the future income distribution, the real key is China and India where 40% of the world's population live.  If they manage to sustain the higher than average growth rates that they have had in the past decade, then we will witness a decrease in inequality in the future.

When we look at the situation in the US, there is a general consensus that things changed rather dramatically in the early to mid 1970s.  How it changed and what caused the change depends upon what variable we use to judge inequality.  One obvious possibility would be wealth and when we look at the wealth data, we find that inequality has increased in the last two decades of the 20th century.  According to Wolff (1998): "In the 1970s, the level of wealth inequality in the United States was comparable to that of other developed industrialized countries.   By the 1980s, the United states had become the most unequal society in terms of wealth among the advanced industrial nations. ... By 1997, one man, Bill Gates, was worth about as much as the 40 million American households at the bottom of the wealth distribution."  In 1995, the wealthiest 1% of the nation owned 47% of the nation's financial wealth while the top 5% controlled 72%. 

A second possibility would be family income.  Evidence of the income inequity can be presented in either tabular or graphical form. The household income data in the first table below indicates that in 1995 one of eight households (12.1%) had an income level under $10,000, while one of seven (14.8%) had income exceeding $75,000.  The share of households in the lowest income bracket was down from the share in 1970 and 1980, while the share in the highest bracket had nearly doubled.  The likelihood of being in one of the top or bottom brackets depended very much upon race and ethnicity.  In 1995, Hispanics and Blacks were both far more likely to be in the bottom bracket and far less likely to be in the top bracket.  Nearly one of every four Black and one of every five Hispanic households had an income below $10,000, but only one of twelve Hispanic and Black families have incomes above $75,000.  For Whites the odds of falling into the lowest bracket were one in ten, lower than the one in six odds of falling into the top bracket.

Money Income of Households
Constant (1995) Dollars

A second popular tabular representation provides the breakdown in family income by relative income position.  In 1995, the top 5 percent of the nation's families earned 20 percent of the nation's income, up sharply from the 14.6 percent in 1980, while the bottom 20 percent of the income distribution earned 4.4 percent of the income, down from 5.3 percent in 1980.  Based on international comparisons of income distribution provided in the 1994 World Development Report, the United States has an income distribution that closely resembles that in the United Kingdom, which places it a bit behind Japan on an equity index and ahead of Mexico and Brazil.  In the US the share of income earned by those in the lowest income group is half the share in Japan and twice the share in Brazil.  Looked at somewhat differently, the top twenty percent of the families in Brazil control thirty times as much income as the bottom twenty percent, while in the US and Japan the corresponding figures are nine and four times.  This differential pattern of income inequality was also cited in Gottschalk (1997) who noted that among the OECD countries, the US experienced the most significant increase in inequality - slightly more that the UK and substantially more than the other European countries and Japan.

Share of Aggregate Income by Each Fifth of Families

The income distribution data can also be presented graphically in the form of the Lorenz Curve which plots the cumulative distribution of income.   The straight line is the picture of a perfectly equitable distribution of income - each 20 percent of the population receives 20 percent of the nation's income.  The further the actual distribution line moves further away from the diagonal, the more inequitable income is distributed. In the diagram below we see that the 1970 line lies above the 1995 line indicating that income is less evenly distributed in 1995 - the same as we see in the table.

But now the real fun begins.  On the surface you seem to have evidence that family income inequality has deteriorated, but there are many problems with the data.  A few of the more important problems are:

• taxes and transfers are excluded:  What matters in income comparisons would be disposable income, but these income figures include taxes and exclude transfer payments.  If transfer payments are included, then you would expect to see a more equitable distribution of income. 
• family data and not individual: Changes in the distribution of income could have to do with "the joint decision-making process among family members who adjust their labor supply, human capital, household formation and childbearing decisions in reaction to changes in outside sources of income, as well as to changes in the earnings of other family members." (Gottschalk 1997).  In the past thirty years there has been a rapid increase in the number of families and a decrease in the size of those families that is not reflected in the income data.  This trend should tend to increase the measures of income inequality even if there were no increase in earnings inequality.  To get a sense of what is happening in the labor market, it is important to move beyond the income data.
• age distribution: Income tends to be related to age and thus the aging of the baby boom generation should have an impact on the distribution of income.  When the boomers were in their early twenties you would expect to have a number of families in the lower income bracket, while once they reach the prime income earning ages ( 45-54), you would expect to see more equality. 
• income data and not earnings: Income comes from a variety of sources and differentials in earnings can be very different from differentials in earnings.  There could be changes in non wage income that dominate equilibrating trends in earnings.  The substantial run-up in stock prices in the 1990s clearly favored those whose income was derived from dividends or capital gains.

While there are a number of factors that contribute to the income inequality, in this section we will focus  attention on one source of that inequality, earnings in the labor market. 

Labor Market: Earnings Growth and Inequality

A good place to start our discussion would be with the question: What is an hour of your time worth? It is a question all of you will need to grapple with at some point in time. Maybe you already have as you have haggled with a boss concerning your wages. It is also a question society has had to grapple with on many occasions. Periodically over the years Congress has stepped in to set the minimum wage - the lowest wage that should be paid for an hour's work in many occupations.   It is also an issue RIU has had to deal with as they attempt to establish a pay scale for university employees. We have also struggled for years with the issue of inequities in the earnings of males, females, and minorities.

But how are wages / earnings determined in our society?   How do we explain and / or alter the distribution of earnings?  We will begin with an old favorite - the supply-demand model of price determination to explain the patterns in earnings. The new wrinkle here will be that we will be using the model to explain wages that can be viewed as the price of labor. 

Labor supply is the result of decisions on the part of individuals choosing choice is between time spent in the labor market earning wages and time spent in non market activity including leisure time and time spent as a volunteer or a student.  One of the factors influencing the choice is the wage rate, which has two potentially distinct effects on the labor supply decision.  First, the increase in the wage rate makes the individual feel wealthier since a higher wage rate will translate into higher income.  This is called the income effect and we expect the increase in income will increase the individual's demand for all goods and services including non market activities.  The choice to increase non market activities, however, means a choice to reduce the hours worked and thus the income effect indicates an increase in wages will lower an individual's supply of labor.

For example, consider the situation facing Mary who has a part-time job earning $7 an hour and worked for 15 hours a week to earn the $105 a week that she needed to support herself while enrolled at RIU.  Here employer, recognizing her talents, has offered her a raise to $10 an hour and Mary now realizes that she can earn her $105 a week in 10.5 hours.  Mary's decision to cut back her hours would be an example of the income effect.

This is not the end of the story, however, since the increase in the wage rate also creates a substitution effect.  Given that the choice is between work and non market activities, the wage rate can be seen as the opportunity cost of non market activities.  By engaging in non market activities, an individual foregoes the wages that could be earned and the wage rate is the price of these non market activities. You know from our previous discussion of demand that an increase in price will reduce demand so you should expect an increase in the wage rate to reduce demand for non market activities. If less time is spent in non market activities, then by definition more time is spent working so we would expect the increase in wages to increase the supply of labor.  Returning to Mary's situation, when the wage rate rose from $7 to $10 an hour, Mary would see the cost of relaxation rising from $7 to $10 an hour and she would be tempted to cut back on her relaxation. 

The individual supply curve will be positively sloped if the substitution effect dominates (below wage rate w* in the Labor Supply diagram below).  If the income effect dominates, we would expect a downward sloping individual labor supply curve - as the wage rate increase the supply of labor will be lower (above wage rate w* in the Labor Supply diagram below).  The market supply curve for labor will reflect these choices of the individuals and thus be dependent upon the relative strengths of the income and substitution effects.  In general economists tend to believe the substitution effect dominates and there is a positively sloped labor supply curve, although this may not be the situation when we look beyond industrialized nations. 

Labor Supply

Labor demand is the result of decisions on the part of firms.  As we have seen earlier (Input Unit), firms are assumed to be profit maximizers and thus the explanation for their demand for labor will be found in the relationship between labor and profit.  Since profit is by definition equal to the price per unit times the number of units sold, the link between labor and profit is to be found in the link between labor and output. [For a review of the subject see the Cost and Production Unit].  The demand for labor depends upon revenue generated by labor which in turn depends on the marginal product of that labor.  If an additional worker can produce 5 units of output and each unit can be sold at $10, then the worker's marginal product is 5 and marginal revenue product is $50 - the most that an employer would pay for the worker. 

What would happen if we increased employment beyond this level?  From our earlier work we know about diminishing marginal product - as employment increases marginal product decreases and therefore marginal revenue product will decrease.  The revenues firms earn from the additional workers is lower, which translates into lower wage offers.  The result is a negative relationship between the amount of labor demanded and the wage rate - a downward sloping demand for labor curve that will shift if there is a change in the price of the output or the productivity of the labor. 

Combining these two elements, we get our traditional supply-demand graph that can be used to explain past movements in wages and forecast future movements.  Immigration, one of the hot topics in the 1990s, has a potentially large impact on certain sectors of the labor market. Individuals in the apparel business may find wages will fall as a result of an increase in the supply of low paid workers resulting from the immigration.  There is also the impact of the internet.  For those interested in employment in the retail sector, one of the concerns about future employment is the rise of cybershopping.  If consumers respond as some experts expect and move to the internet to do their shopping, then the demand for goods and services in traditional stores will decline which should pull demand for these retail workers down.  For someone interested in management information systems, meanwhile, the year 2000 bug increased demand for information technology graduates, which translated into higher salaries. These examples highlight an important feature of demand for labor - it is a derived demand in the sense the demand for labor is dependent on demand for the output produced by that labor.  A decrease in demand for automobiles or retail shopping will translate into a reduced demand for auto and retail sales workers.   

Labor Market

Now that we have the framework for our analysis of the labor market, we can look at the data to see what has happened to average earnings.  One of the constants in life in the early post WWII era in the US was an increase in the standard of living. The primary measure of this improvement was the inflation adjusted real wage level for production and non supervisory workers which by 1973 had risen nearly two-thirds above its 1948 level. This changed, however, in the 1970s. After a virtually uninterrupted climb beginning after WW II, real (inflation adjusted) wages for American workers stopped rising in the recession of 1973-75 and continued to fall for the remainder of the decade.   By 1996 nearly one-half of all the gains made since 1948 had disappeared and real wages stood at the same level they had been in the 1950s.   [Note: The adjustment for inflation became a hotly debated topic in the late 1990s. It turns out that the extent of the decline depends upon the adjustment that is made. In fact the decline is eliminated with some adjustment techniques].

This one graph seemed to capture the anxiety of the American people and the disillusionment with the economy in the late 1970s.  It was this disillusionment that Ronald Reagan tapped into in his successful presidential bid in 1980.  As we saw in the unit on antitrust and regulation, it was also a catalyst behind the deregulation movement and weakening of the antitrust stance during the 1980s. In the macroeconomics course, you will discuss how this end of growth helped shift the ideological balance from the liberals and their Keynesian economics to the conservatives and their supply-side economics.

Reagan offered the American people a way to get moving again.  As we move into the 1990s, the search continues for the culprit - the cause of the decline. The favorite candidates are decreases in demand caused by the movement of manufacturing jobs oversees into cheap labor countries and increases in supply caused by the inflow of immigrants that have reached historically high levels. Neither has proven to be a completely satisfactory result, but we should expect to see increasing pressure to limit trade and restrict immigration as the wage trend continues.

On the earnings differential front, the differentials continue to persist and improvements appear to be slow at best.  What you can be certain of is that even a casual review of the discussions on wage inequality and the distribution of income will introduce you to what appear to be contradictory statements based on the 'facts.'  It is a perfect opportunity to see first-hand the problems associated with data analysis.

There is no question wages differ - and they differ across many dimensions.  You would not need to look to far at the University to find evidence of substantial earnings differentials.  Examples of some of the differences appear in the table of data on 1994 earnings. Workers in the electric, gas and sanitary industry earn 160 percent more than those in retail;  middle age workers earn about 67 percent more than younger workers; and of course the one that matters most to many of you, college grads earn substantially more than high school grads.  There are also substantial racial, ethnic, and gender differentials.  Blacks and Hispanics earn approximately one-third less than Whites - approximately the differential between males and females.  Relative to the industrialized nations of the world, the US is in the middle of the pack in terms of earnings differentials.  At the top of the equality list is Sweden where females earn 90 percent of males, while at the bottom of the list is Japan where the rate is 50 percent.  The figure for the US was 75 percent. (Waldfogel 1998). Marital status also matters - at least when we look at the earnings of females.  Waldfogel points out the existence of a "family gap" which she defines as the difference in the earnings of women with and without children.  According to Waldfogel, "the gap between women with children and those without children has been widening." 

Annual Earnings: 1994

But why do earnings differ so much? This is the question we are going to examine in the remainder of this unit and a useful a starting point will be the diagram below that describes the relationship between two labor markets (A and B). These could be considered to be two occupations, two regions, two countries... What we see is that in Diagram A the equilibrium wage is higher than it is in Diagram B. The questions are: what explains these differences and are they sustainable?

At the most basic level, we can view the problem as one where the relative scarcity of labor in A is higher than it is in B, the balance between supply and demand favors supply in B and demand in A. The usual suspects when we look for explanations to wage / earnings differentials would include the following factors.

• compensating differentials
• ability and skills
• imperfect competition
• discrimination

We will look at each of these factors, and to better understand the nature of our work, consider the following problem.  Is there gender discrimination at RIU?  The evidence initially presented was the existing difference in the average earnings of male and female faculty.  Is this evidence of discrimination?  Before moving on I would suggest you take a moment to consider your answer - and try very hard to get past your initial reaction.  Experience has shown this is a question people have been sensitized to and they enter the discussion with some very strong opinions, opinions that are not always based on the facts.  Once you have formulated the outlines of your answer, you should move on to a discussion of the four determinants of earnings.  When we are done we will return to finish off our discussion of inequality with a review the research on rising inequality and a discussion of poverty.    

Given this framework, what can we say about recent patterns of earnings inequality.  If we do move beyond the income data and examine earnings, as the authors in the Journal of Economic Perspective's symposium on Wage Inequality did, you will find that " a large descriptive literature has documented the rise in inequality, while a smaller behavioral literature has sought to delineate the causes of the rise.  . . .  The 1980s and early 1990s can be characterized as a period of slow growth and rising inequality.  (Gottschalk 1997)   What the descriptive literature has found is:

• mean earnings growth has slowed since 1973, but the magnitude of the growth slowdown is dependent upon the adjustment for inflation. 

• earnings growth depends upon initial earnings.  For both males and females, average annual growth rates were positively related to initial income level.  The differences between the two had to do with the level of earnings growth.  Males in the lowest 3/4s actually experienced earnings losses while all female income groups experienced income growth. The gap between the top and the bottom of the earnings distribution for males began to rise in 1973 after remaining fairly constant in the prior decade, while the rise in female inequality beginning in 1973 reversed a decade long pattern of decline. (Gottschalk 1997)

• gender differential continued to fall throughout the period  while the declining racial differential stopped in the mid 1970s.

• college premium increased sharply in the late 1970s and continued to rise into the mid 90s, reversing a downward trend dating from the early 1960s. In the 1979-93 period the ratio of college-educated to high school-educated workers rose at a rate of approximately 1.2 percent a year. The education premium has risen steadily since the late 1970s  (Tofel 1997)

• experience premium increased since late 1960s;  the experience premium has been rather flat since the early 1980s (Tofel 1997)

• variability in earnings increased since the mid 1970s

• income mobility exists, but it is not overwhelming.  The odds that someone in the lowest 20 percent of the earnings distribution would be there in 1991 was 42% while the odds of remaining in the top bracket was 54 percent.  The odds of someone in the second lowest quintile (21-40 %) either remaining in the same bracket or falling a bracket was nearly 66 percent. 

With regard to demand, supply, and institutional sources of inequality,  the behavioral literature found that:

• increase in relative demand for workers at high end of the skill spectrum in the 1980s.  The causes cited are increased openness and skill-based technological change. (Johnson 1997). 

  • trade growth is overrated since the number of unskilled jobs lost in tradable goods sector is small; demand growth preceded the explosion in trade deficit in the 1980s; and up-skilling took place across all sectors, not just the tradable goods sector. 

  • skill-biased technological change can be of three types:
    intensive - skilled workers become more productive in jobs they already performed (computers)
    extensive - skilled workers become more efficient at jobs formerly done by unskilled workers (robots)
    neutral - all workers' productivity increases proportionally
    The evidence suggests that extensive change is the most important type, that firms are "up-skilling" their work forces.  This is a situation we find in other industrialized countries.  (Johnson 1997)

• supply-side effects can also affect the premium paid to skilled / better educated workers. Oft-cited supply-side effects have been the rise in immigration, cohort size, education, and the increasing labor force participation of females.  (Tofel 1997)

• the wage premium should depend upon the elasticity of substitution between skilled and unskilled labor.  As the elasticity increases and the two types of labor are more interchangeable, the impact of changes in the relative supply  on relative wages decreases.   

• immigration has minimum impact on earnings, even among the low skilled.  One possibility would be that the supply of native labor is very elastic - as new immigrants move in, natives move out. 

• the movement of the baby boomers into the market pushed down wages in the mid 1970s, but the wage dip dissipates as the boomers age.

• the increase in supply of college-educated workers decelerated in the 1980s which helps explain relative decline of college-educated earnings in the 70s and the reversal in the 80s. 

• cannot find evidence of a substantial crowding-out effect caused by the increased labor force participation of females

• institutional factors also have the potential to influence relative earnings.  Three institutional changes that could have been related to the inequality are a declining real value of the minimum wage, a decline of unionization, and the movement toward deregulation.  Possibly as much as one-third of the wage inequality during the 1980s can be traced to these institutional changes.   (Fortin & Lemieux 1997)

• the decline of unionization has significant impact on inequality of males' earnings

• the decline in the minimum wage has a significant impact on the inequality of females' earnings

• deregulation tends to have a rather small impact on inequality

What can we conclude from these findings?  The United States trails the rest of the industrialized nations when it comes to inequality and in the last two decades of the 20th century inequality increased - both within the US and worldwide - increased substantially. While we can agree on the inequality, there is no consensus on the appropriate explanation for the increasing inequity that the US experienced in the 1980s and 1990s.  It is safest to conclude that it has been the result of a combination of demand-side, supply-side, and institutional factors.

And where do we go from here?  It's now time to take some time and reflect on what we have seen during our foray into microeconomics. A good place to start would be a return to the opening of the course and review the course goals.