Firming Up Inequality

Another day, another NBER paper. ‘Firming Up Inequality’, by Jae Song et al., is about a year old, but the latest version is from this summer (pdf). This paper uses a comprehensive matched employer-employee data set to investigate just how changes in inequality have played out between and within firms.

The fact of dramatic increases in wage inequality in the US is well documented, but there is considerable disagreement on its root causes. As we’ve seen argued in books like The Wealth of Humans, skills biased technical change is one hypothesis, which boils down to changes in markets rewarding a particular subset of workers. Another hypothesis is that changes in inequality are mostly due to the powerful members of society extracting economic rents.  A common example of this is the relative rise in American CEO pay vs other developed countries. If this rent seeking hypothesis were true, we would expect to see increasing inequality within firms, as CEOs and other top managers captured greater shares of firms’ profits.

What they find is that the majority of the increase in income inequality is actually explained as a between-firm phenomenon, not a within-firm phenomenon. Furthermore, this finding holds across industry sectors, region, demographics, firm size (with one exception; see below), etc. It’s not the case that there has been any sort of differential growth leading to this.

Finally, they find that there has been one type of firm that has seen increases in within-firm inequality: the ‘mega-firm’, i.e. a firm with more than 10,000 employees. In the US there are around 800 mega-firms that employ about 20% of the workforce, and these have seen both decreases in the lower end and increases in the higher end of the income distribution. In the authors’ estimates, the median worker in such firms saw earnings fall around 7% from 1981 to 2013; in contrast, the top 10% saw increases averaging around 11%. And the managers at the very top in these firms have realized real earnings increases of 137%.

So what’s going on here? Most firms are becoming more equal internally, yet firms as a whole are becoming less equal.  And at the same time, the very largest firms are seeing the opposite pattern.

Song et al. propose two potential explanations for the increased in interfirm inequality: a ‘widening firm premium’ story, or a ‘worker segregation’ story. In the former, firm inequality is driven by the fact that some firms are winners and others losers in the economy; winners may end up distributing their increased gains to their employees, while losers cannot. In the latter story, workers are increasingly being sorted into firms by ability; high-ability and low ability workers are clustering into separate firms, rather than mixing together.

What they find is strong support for the worker segregation story. This accords with other research from European countries that finds increased segregation by occupation, education, and ability across firms. This suggests that firms are focusing more on their core activities and outsourcing the rest. Once upon a time, a consulting firm may have employed a host of people beyond the consultants: janitors, building maintenance, maybe some in house tech people to run the email server, and so on. Nowadays, all of those support activities can be easily outsourced, thanks to technological change.

The mechanism here was actually identified long ago, in one of the most seminal papers in all of economics: ‘The Nature of the Firm’ (pdf, and very readable for an economics paper), published in 1937 by Ronald Coase. It’s easy to take the existence of a firm for granted, but Coase did not. He wondered why it should be that people should join together in firms, which internally can have all sorts of inefficiencies and rigidities, rather than flexibly using contracts to bind independent workers together for projects. His conclusion is that transaction costs explain the existence of firms: searching, information, bargaining, enforcement, etc. all have costs. When they are high enough, firms will tend to internalize those externalities rather than engage in market activity.

Think again of that consulting firm. Maybe the entrepreneur that started it can get business for dozens of projects every year. In a frictionless world, he would want the best person for each project; maybe this year there’s been a lot more antitrust cases coming his way, so he contracts with some good antitrust people. Maybe next year there will be a lot of environmental regulation cases; he’ll want people with that particular experience next year.

But of course, finding those particular people has costs. The ads must be posted; the candidates interviewed; the contracts drawn up. In many cases, the opportunity cost of having a more average talent set is far less than these transaction costs. This argument can then be extended to all sorts of workers within the firm, like those aforementioned support roles.

So in a world where transaction costs have become lower due to technological change (particularly search and information costs), we should expect there to be changes in the structures of firms. I find it interesting that there is no apparent trend towards smaller firms, as might be predicted by Coase; instead firms seem to be replacing outsourced positions with more of their core competencies. And since firms are trending towards employing the same kinds of people in the same kinds of occupations, we see this increasing inter-firm inequality.

Now what about the megafirms, where intrafirm inequality is increasing? Why has median pay decreased over time? The paper suggests that what’s going on is that the lowest skill workers are seeing a wage convergence with their counterparts in smaller firms; previously they were earning a premium that has faded by about 20%. The mechanism here is left unclear, but we should ask ourselves why these workers had a premium in the first place.

Song et al. also look at the top 1% of these megafirms and find a strong correlation with earnings of the top employees and the annual S&P 500 change, which strongly points towards the increase in stock options for CEO compensation as the culprit. (Which, as an aside, originated from an ill conceived attempt to limit executive pay). I found this figure particularly striking:


I’m still puzzled by the fact that average firm size is not decreasing and is in fact slowly increasing. There must be some countervailing force, perhaps internal network effects, or the increasing returns to social capital, that induce firms to grow larger even as they concentrate their activities. Something to think about.


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