On the wage–productivity causal relationship

Abstract

In a perfectly competitive labor market, wage rates are determined by labor productivity, so that wage dispersion reflects the marginal contribution to product of the different workers. Accordingly, wage inequality cannot be treated as an independent variable in a model of productivity, and thus economists have paid little attention to this relation. This paper studies the effects of wage inequality on labor productivity. We claim that wage inequality can lead to lower effort among workers who receive lower wages and hence lead in turn to lower aggregate labor productivity because of the lower aggregate effort level. To guide the empirical analysis, we look at aggregate panel data to investigate whether there is a relationship between wage inequality and average labor productivity. We use data for 34 OECD countries in the period 1995–2007, and by allowing country fixed effects, we exploit the longitudinal dimension of the data. We find that large wage inequality is associated with lower labor productivity. So the results suggest that higher levels of the Gini index of wage inequality are associated with lower labor productivity. Moreover, we study the question of whether wage inequality that causes productivity level or viceversa by assessing non-causal homogeneity in a panel Granger framework.