Abstract
AbstractThis article considers methods for decomposing wage variation into individual and group specific components. We discuss the merits of these methods, which are applicable to variance decomposition problems generally. The relative magnitudes of the measures depend on the underlying variances and covariances, and we discuss how to interpret them, and how they might relate to structural parameters of interest. We show that a clear‐cut division of variation into area and individual components is impossible. An empirical application to the British labour market demonstrates that labour market area effects contribute very little to the overall variation of wages in Britain.
Highlights
This article considers methods for decomposing wage variation into individual and group specific components
The uncorrelated variance share provides a lower bound to the contribution of exogenous area effects alone
We have shown why disentangling the contribution of area effects to wage distribution is complex, and why an approach based on bounds such as raw variance share (RVS), balanced variance share (BVS), correlated variance share (CVS) and uncorrelated variance share (UVS) can only provide guidance to the relative importance of area effects
Summary
You are under no obligation to analyse variance into its parts if it does not come apart and its unwillingness to do so naturally indicates that one’s line of approach is not very fruitful. For example, Krueger and Summers (1988), Gibbons and Katz (1992) and Abowd, Kramaz and Margoli’s (1999) Another example occurs in urban economics when considering the extent to which sorting matters for individual and area disparities in wages. For example, Duranton and Monastiriotis (2002), Taylor (2006), Dickey (2007), Mion and Naticchioni (2009), Dalmazzo and de Blasio (2007) and Combes, Duranton and Gobillon (2008) Education economics provides another example, where the interest is in finding out the contribution of schools to the variance of pupil test scores The results here illustrate that area effects make only a small contribution to overall wage inequality, and that observed disparities between mean wages in different areas are primarily due to sorting
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