Mind the wage gap

What impact does a corporation’s shape and size have on labour costs? Much less attention has been paid to the influence of the boundaries of firms than has been given to the effect on the business’ value and allocation of investment.

Are wages higher or lower in conglomerate businesses operating in many different spheres than those paid by stand-alone, single-industry businesses? In particular, how does this affect lower-wage occupations?

My research shows that there is very definitely an effect, with those in lower-paid lines of work inside a conglomerate enjoying higher levels of pay than their equivalents in the same lines of work in stand-alone businesses. There is, in other words, a direct relationship between the “firm boundary” and levels of pay.

Finding out how this relationship works requires an exploration of the ways in which companies may set wage levels.. One traditional economic view is that wages are related only to the marginal productivity of the worker or workers concerned, i.e. the additional output arising from employing the person or people concerned.

In this view, the shape of a firm has no influence on wage setting other than indirectly, when a larger company may have higher levels of productivity than a smaller one.
A much more nuanced view would start from the “utility” – the total benefit – that employees derive from their wages. Thus alongside better purchasing power, highly-paid workers enjoy a “status utility”, or status benefit, from their bigger pay packets in comparison with the smaller earnings of lower-paid workers.

By contrast, the lower-paid workers suffer a “disutility”, or negative benefit, from the same comparison. Viewing this in fairness terms, they may respond with actions of sabotage or revenge against the business.

Over compensating

In these circumstances, it may make sense for firms to pay these workers a wage higher than the marginal productivity of their labour.

Even were the “utility” argument to be put to one side, big wage differentials may well send signals as to what sort of company this is – unwelcome signals that could undermine the firm’s reputation both with its own workforce and the outside world. Again, it may make sense to award the lower-paid workers more than the “going rate”.

Then there is the danger that disgruntled lower-paid employees will “rent seek” – shirking, perhaps, or frittering away what ought to have been working time in trying to gain influence with managers or supervisors. This, again, may give the firm an incentive to pay more than would normally be thought justified.

Closing the gap

Thus in the context of a conglomerate business, diversified across a number of industry sectors whose pay levels are traditionally quite varied, there is demonstrable pressure to reduce differentials and evidence that the dispersion of pay rates is indeed reduced, to the benefit of those at the lower end of the pay scale. When the diversified conglomerate includes both high and low wage industries, those in the latter sectors can expect to be better paid than their counterparts in single-sector stand-alone firms.

Looked at one way, this is not surprising. Workers gauge their own earnings in part against the earnings of those who are better paid: if they perceive unfairness then they may respond in the ways we discussed earlier. Furthermore, some corporate executives have taken the initiative in terms of promoting what is known as “internal equity”, trying to narrow wage differentials within the business.

Of course, the story does not end here, with traditionally lower-paid employees in diversified firms enjoying pay above the industry average for evermore. If the shape of a firm has a direct effect on the compensation of lower-paid workers, then this wage effect in turn has a dramatic effect on the firm’s investment behaviour.

Automatic response

As may have been expected, the convergence of lower-paid people towards higher-paid workers in the same corporate group prompts the company concerned to invest more in capital equipment and less in labour. After all, it is in competition with stand-alone firms in the same line of work whose employees are paid less. A wedge has opened up between the competition’s labour costs and those of the conglomerate.

It makes sense to try to regain that competitive advantage through labour-saving investment, replacing more expensive workers with relatively less expensive capital.

With no understanding of the wage effects within a conglomerate, much of this investment may seem irrational to an outsider. It appears to involve higher investment in what are normally thought of as low-investment business areas. But while an outsider may suspect that capital is being misallocated, the higher wages paid to workers inside a conglomerate in relation to their counterparts in stand-alone businesses may well make investment in automation the best choice economically.

My research uses data from the US Census Bureau and is adjusted to take account of factors such as levels of union membership, the geographical influences at work and the state of product market competition. It shows clearly that there is a cost to be paid in terms of higher pay levels from bringing together under one conglomerate umbrella a number of different activities with traditionally different pay levels. It shows also that firms respond to the loss of competitive advantage incurred by trying to offset it through replacing workers with automated equipment.

Going one step further, does my research “prove” that corporate diversification is inefficient and that businesses ought to focus on one industry or sector? By no means. The decision to diversify can never be driven solely by pay considerations. Those firms that chose to take the conglomerate route may enjoy benefits from doing so that more than make up for the higher wage costs involved.

I am happy simply to set out the case that such costs exist.