CENTRE FOR ECONOMIC PERFORMANCE DISCUSSION PAPER NO. 219 DECEMBER 1994 WAGES, EFFORT AND PRODUCTIVITY S. NICKELL AND D. NICOLITSAS

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1 CENTRE FOR ECONOMIC PERFORMANCE DISCUSSION PAPER NO. 219 DECEMBER 1994 WAGES, EFFORT AND PRODUCTIVITY S. NICKELL AND D. NICOLITSAS

2 ABSTRACT Emprcal analyses of longtudnal data on some 66 manufacturng companes n Brtan lead us to the followng three conclusons. Frst, agreed reductons n restrctve work practces lead to ncreases n productvty. Second, controllng for such agreed reductons, there s some weak evdence that both relatve pay and aggregate labour market slack have some postve mpact on productvty. Thrd, falls n market share or declnes n the fnancal health of companes lead to both lower pay rses and reductons n restrctve practces. Ths paper was produced as part of the Centre's Programme on Corporate Performance

3 WAGES, EFFORT AND PRODUCTIVITY S. NICKELL AND D. NICOLITSAS DECEMBER 1994

4 Publshed by Centre for Economc Performance London School of Economcs and Poltcal Scence Houghton Street London WC2A 2AE S.Nckell and D.Ncoltsas ISBN

5 WAGES, EFFORT AND PRODUCTIVITY Stephen Nckell and Daphne Ncoltsas Page Introducton 1 1. The Analytcal Framework 2 2. The Emprcal Formulaton 7 3. Results Conclusons 14 Endnotes 15 Appendx 16 Tables 18 References 27 The Centre for Economc Performance s fnanced by the Economc and Socal Research Councl.

6 ACKNOWLEDGEMENTS We are most grateful to the Leverhulme Trust for fundng ths work and to the Confederaton of Brtsh Industres and Peter Ingram for allowng us to use some of ther data on pay settlements.

7 WAGES, EFFORT AND PRODUCTIVITY Stephen Nckell and Daphne Ncoltsas Introducton Many people beleve that companes whch are dong well pay ther workers more than companes whch are dong badly. Another commonplace belef s that payng workers well motvates them to work harder, and thus enables the company whch employs them to mprove ts performance. It s clear from ths that the causal relatonshps between pay, effort and company performance are nothng f not complex. In the market for labour, the forces of competton wll generally ensure that ndvduals who are consstently hard-workng wll obtan hgher wages. Asde from ths, what other forces mght be at work? Suppose, for example, that pay results from a frm-unon bargan. Suppose further that the unon sde s concerned wth both wages and job securty. Then any exogenous factor whch generates a ceters parbus mprovement n job securty leads to the unon achevng hgher wages n the bargan. Examples of such factors nclude an ncrease n the market power of the 1 company or an mprovement n ts fnancal poston. So ths mples a drect causal lnk between the mprovement n company performance and the subsequent ncrease n pay. Ths lnk can also apply n non-unon frms f the mprovement n performance s assocated wth an ncrease n product market rents or free cash flow whch s then shared wth the employees. Where mght employee effort enter ths story? In the majorty of unon plants 2 n Brtan, barganng takes place over effort as well as pay. In ths case f an mprovement n the fnancal poston of a company, for example, leads to the unon obtanng a bgger pay ncrease, such an mprovement wll also enable t to bargan for lower effort. So n ths context, we mght expect to observe an mprovement n company performance generatng both an ncrease n pay and a reducton n effort. We could, therefore, observe a negatve relaton between effort and pay n response to certan types of shock.

8 Where does ths leave the motvaton argument noted at the begnnng of ths secton? The use of pay to motvate workers s a standard dea n the lterature on human resource management, and comes n very drect forms such as pece rates or performance related bonuses. The effcency wage lterature has generated a more subtle noton n the form of the shrkng model (see Shapro and Stgltz, 1984). The dfference here s that whle performance pay relates wages to readly observed outcomes, the shrkng model generates a postve relatonshp between effort and pay n stuatons where ndvdual effort s not readly observed. The dea here s that hgher pay leads to a reducton n shrkng because the penalty for beng caught shrkng, namely job loss, s more serous f wages are hgher. Our purpose n what follows s to try and shed some lght on these ssues usng longtudnal data on a group of UK manufacturng companes, ncludng some nformaton on changes n observed effort. We shall nvestgate a number of questons. Frst, can we detect a relatonshp between our measure of observed effort and company productvty? Second, controllng for observed effort, can we detect any effcency wage effects on productvty? Thrd, do ncreases n market power or mprovements n the fnancal poston of companes lead to hgher pay rses and reductons n effort? Our man focus wll be on the frst and thrd questons. The second we see as a more speculatve endeavour because the detecton of effcency wage effects n a producton functon framework s fraught wth problems. 1. The Analytcal Framework In ths secton we consder the theoretcal and emprcal background to the determnaton of productvty and to the determnants of wages and effort n a barganng framework. The determnants of productvty The bass of our analyss s the producton functon. Output s a functon of labour, captal, workng hours plus the "effort" of both operatves and managers. Here we use the term "effort" n a broad sense to cover anythng that workers and managers do to mprove company productvty whch rases the dsutlty of work. Increased effort wll rase measured effcency (the level of productvty) and, partcularly n the case of manageral effort, t may also rase productvty growth as managers contnuously search harder for better ways of dong thngs. Frst, consder these growth effects. An nterestng hypothess, whch s extensvely analysed n Nckell (1993), s that manageral effort s nfluenced by the extent of product market competton. That s, competton acts as a spur to managers, leadng to a hgher rate of productvty growth. Ths dea wll be nvestgated n what follows but wll not be our man focus. Here we concentrate on level effects, partcularly the role of effcency wages. As we have already noted, t s mportant to recognse that effcency wage effects operate va unobserved effort. In the standard shrkng model of Shapro and Stgltz (1984), shrkng s not readly observed and hgher (unobserved) effort s nduced by payng wages n excess of outsde opportuntes. Ths works because the frm undertakes some lmted montorng of workers and f they are caught shrkng, they lose ther jobs. The hgher the wage relatve to outsde opportuntes, the greater the cost of job loss and the greater the ncentve not to shrk at gven levels of montorng. If worker effort s readly observed, the unformly hgher wages are 2

9 unnecessary because workers can be pad drectly n relaton to ther effort. In realty, of course, there are both observed and unobserved aspects to ndvdual effort and t s only the latter to whch effcency wage arguments apply. For example, observed effort ncludes, most obvously, hours of work, and also 3 mannng ratos on machnes and the flexblty of workng practces. Less readly observed aspects of effort relate to ntensty of work, care taken over qualty, and the lke. In order to capture these effects, we use a constant returns log-lnear producton functon of the form (1) where y = output, n = employment, k = captal stock, h = workng hours, e = o observed effort, e = unobserved effort, g = productvty growth and g = all other u factors. s the frm ndex, t s the tme ndex, $ s an unobserved frm effect and t$ s a tme effect. The latter two varables capture all tme nvarant frm specfc factors and all tme varyng factors common to all frms. In our emprcal work, the most mportant purpose served by ths model s to check that our measure of observed effort really does nfluence productvty. We shall also, however, nvestgate competton effects on productvty growth by supposng that g = g(competton ) (2) + and effcency wage effects va unobserved effort by specfyng e ut = e u (W t /W t,u jt ), (3) + + where W /W = relatve wages and u j = the ndustry unemployment rate. What do we know about these effects? On the effcency wage front, we have some drect frm level producton functon evdence that wages nfluence productvty (see Wadhwan and Wall, 1991 and Levne, 1992). Unfortunately nether of these studes control for observed effort and the former does not control wages for skllmx ether. These omssons naturally create a potental correlaton between productvty and wages whch can corrupt the relatonshp we are lookng for. Other producton studes tend to use more aggregatve data and generally fnd a postve unemployment effect on productvty. (See Oster, 1980; Rebtzer, 1988 or Green and Wesskopf, 1990, for example). Concernng competton and productvty growth, Gerosk (1990) fnds clear evdence that ncreases n monopoly power tend to reduce the rate of nnovaton and 4 hence productvty growth. Nckell (1993) fnds evdence that frms wth a large number of compettors tend to have hgher (total factor) productvty growth than those facng less competton. Otherwse there s lttle evdence avalable. 3

10 The determnaton of observed effort and wages Snce ths s to be the man focus of our emprcal nvestgaton, t helps f we can pn down rather precsely the mplcatons of a smple theory. Here we suppose that frms and unons bargan over wages and effort, and then, output, employment and prces are determned va a Cournot-Nash equlbrum. The ndustry settng s that descrbed n Nckell (1993). There are n frms producng a homogeneous good. Frm has technology " Y = N (EN), "<1 (4) where Y s output, N s employment, E s observed effort and N reflects other factors nfluencng frm productvty. Industry prce P satsfes -1/0 P = [EY /Y ] (5) d where Y d s a demand ndex and 0 s the ndustry demand elastcty. The sequence of events s as follows. Frst frm and unon pars bargan ndependently about effort, E, and the wage, W. Then frms n the ndustry set output and employment at the Cournot-Nash equlbrum. At the second stage, we can show that employment n frm satsfes (6) where MS = Y/EY, the market share of frm. Usng ths and (4), (5), we can show k that the market prce P satsfes Ths enables us to show that (7) (8) and that proft, B, s 4

11 (9) Turnng to the frst stage, we use the generalsed Nash barganng framework. The unon contrbuton to the Nash bargan we specfy as [Wg(E )-U6 ]N, whch s consstent wth a utltaran unon objectve. Wg(E ) s the utlty of a representatve unon member and U6 s the utlty whch the unon member can obtan outsde the frm. The contrbuton of effort to utlty, g(e ), s assumed to be decreasng n effort at an ncreasng rate (g < 0, g" < 0). Takng the frm's contrbuton to the Nash bargan to be ts proft, the Nash objectve has the form (10) where $ reflects the power of the unon n the bargan. In order to ntroduce fnancal pressures on the frm arsng from hgh levels of debt, say, we smply constran the frm to make a proft greater than some fxed amount Bˆ, n order to cover debt servcng, for example. So wages and effort are determned by solvng The Lagrangan for ths problem s gven by and, usng (9), the Nash bargan reduces to solvng The frst order condtons are (11) (12) 5

12 where (13) Furthermore, there s the usual complementary slackness condton, (14) Some elementary manpulaton then yelds (15) (16) For our purposes, the relevant comparatve statc results are (17) 6 (18) Snce 8 s non-decreasng n the proft constrant, Bˆ, these results ndcate that an ncrease n fnancal pressure or a reducton n market power (fall n market share) wll lead to an ncrease n barganed effort and a reducton n wages. The utlty avalable outsde the frm, U6, s a functon of outsde opportuntes. In partcular t wll depend postvely on outsde wages and negatvely on aggregate unemployment. Changes n these varables wll nfluence wages but not effort n ths smple framework. Fnally t s worth notng that (16) mples that for a gven state of the outsde labour market, wages and effort move n opposte drectons. It s our purpose to nvestgate all these hypotheses wth our company data set. Evdence on the mpact of market power and fnancal pressure on wages s now readly avalable. For example, Nckell and Wadhwan (1990) and Carruth and Oswald (1989) provde clear evdence that fnancal pressure lowers pay, and the role of market power n enablng managers to pay hgher wages s clearly demonstrated n Veugelers (1989), Stewart (1990), Konngs and Walsh (1993) or Nckell et al. (1992). However, there s not drect evdence that these same forces shft effort n the opposte drecton. It s our nvestgaton of ths ssue whch s our man clam to

13 orgnalty. 2. The Emprcal Formulaton We shall use panel data on UK manufacturng companes to nvestgate the varous hypotheses dscussed n the prevous secton. Our basc data source s the publshed accounts of 66 UK manufacturng companes over the perod All the companes are unonsed. Added to these data s nformaton from the annual Confederaton of Brtsh Industres (CBI) Survey of wage settlements whch has been 5 matched to the accountng data. We shall dscuss some of the data defntons here because they have mportant mplcatons for the nterpretaton of the results. Complete defntons may be found n the appendx. The productvty equaton Ths s based on the model set out n the prevous secton n equatons (1), (2), (3). The followng varables are of partcular nterest. Employment elastcty, ". Ths coeffcent s equal to µ s, where µ s the mark-up of prce on margnal cost and s s the share of labour (see Hall, 1986, for example). Snce we have no accurate measures of µ, we ether treat " as a constant or suppose t to be a lnear functon of the (average) share of labour for each frm. -1 Hours, h t. We follow Muellbauer (1984) and use " 11(H ojt/h njt) + " 12 (H ojt /H njt ) where H oj measures overtme hours per worker n ndustry j and nj H measures standard hours per worker. Ths captures the asymmetry arsng from the fact that measured hours tend to overstate actual hours worked n slumps. Observed effort, e. The only varable avalable s from the CBI data set and ot measures a change n observed effort. It s a dummy varable whch takes the value 1 f the annual wage settlement ncludes an agreement by workers on the removal of restrctve practces. These nclude the elmnaton of neffcent work practces, the removal of demarcaton rules about whch sorts of workers are allowed to undertake whch sorts of jobs, and generally nvolve an ncrease n the flexblty of the workforce. Ths typcally reflects an ncrease n "effort" on the part of workers, both n the lteral sense and n the sense that elmnatng restrctve practces rases the dsutlty of work. Unobserved effort, e ut. Here we smply follow the standard effcency wage formulaton (equaton (3)) and utlse relatve wages and ndustry unemployment. Aggregate unemployment effects are absorbed n the tme dummes. Competton. The varables we have avalable here nclude the average market share at the frm level, the average concentraton rato and mport penetraton n the ndustry n whch the frm s located, and a frm based measure of rents. Our measure of market share s not satsfactory as a relatve or cross-secton ndcator of market power because the denomnator refers to (3 dgt) ndustry sales, whch s smply not the correct `market'. Furthermore, ts relatonshp to the correct market wll vary systematcally across ndustres. So, whle tme seres fluctuatons n ths varable may well capture qute accurately varatons n the true varable over tme, 7

14 as a cross-secton varable t s useless. The ndustry varables may be of some value, but n our vew, the rents varable s the most promsng. We have computed for each frm a measure of rents normalsed on value added averaged over a ten year perod. Rents are defned as pre-tax profts plus nterest payments and deprecaton less the product of the cost of captal and the captal stock at current replacement cost. The dea s that frms facng less competton wll generate hgher rents n the long run. Of course, what we really requre are potental rents snce part of our basc argument s that these are dsspated n the form of lower effort or captured n the form of hgher wages. So what we have s a measure of the rents that the shareholders obtan. Insofar as these are roughly proportonal to potental rents, ths varable s satsfactory. So the equaton whch serves as the bass of our nvestgaton of 8

15 company productvty has the form (19) where y = output, n = employment, k = captal stock, H = overtme hours, H = oj nj standard hours, mksh. = average market share, conc j. = average 5 frm ndustry concentraton rato (3 dgt), mp. = average ndustry mport penetraton (3 dgt), j rents. = average rents per unt of value added, d = two dgt ndustry dummes, RRP j = reduced restrctve practces, (.e. f RRP s hgh, the level of restrctve practces s low and effort s hgh) w - w = relatve wage, u j = ndustry unemployment, = frm, j = ndustry. We have allowed smple dynamcs n the equaton n the form of a lagged dependent varable, to capture the possblty that whenever a factor of producton s changed, t takes some tme for output to reach ts new long-run level. The key varable nfluencng productvty growth s that capturng product market power n the form of rents, namely rents.. The other varables, namely market share, concentraton, mport penetraton and ndustry dummes (d ) are ncluded j smply as controls. We have already noted that our measure of market share s not adequate n a cross-secton context. Concernng productvty levels, we have lower levels of restrctve practces (RRP) capturng observed effort, and relatve wages and ndustry unemployment to pck up effcency wage effects. These are all lagged one perod n order to allow them tme to nfluence productvty, and to try and elmnate reverse causalty effects. In order to estmate the parameters of (19), we elmnate the frm effects ($ ) by takng frst dfferences to obtan 9

16 10 (20) Ths has certan mplcatons. Frst, the error term wll contan productvty shocks assocated wth both employment composton and ntensty of factor use. So we must treat both current employment and captal as endogenous. Furthermore, after dfferencng, y s also correlated wth the equaton error. However, so long as the t-1 basc error,,, s serally uncorrelated, then all lags on y, n and k beyond t-2 are t vald nstruments. IV estmators based on ths fact have been proposed by Arrelano and Bond (1991) and are used here. Second, t s worth notng that our data on restrctve practces and company wages come n frst dfference form. For the former, we know when restrctve practces are reduced (.e. )RRP takes the value 1 f restrctve practces are reduced, zero otherwse). For the latter, we have nformaton on the percentage pay rse for a partcular manual group n the pay settlement. For present purposes, ths s partcularly valuable because t cuts out both hours effects and skll composton effects, both of whch generate natural postve correlatons between average earnngs and productvty. However, there s stll the danger of reverse causalty for both restrctve practce and effcency wage varables (.e. frm does badly and so removes restrctve practces, frm does well and pays hgher wages), so as well as laggng, we treat all these varables as endogenous. The wage/effort model Ths s based on the theoretcal model set out n the prevous secton. The results n (17) and (18) ndcate that both wages and effort are functons of market power and fnancal pressure, but only the former s nfluenced by external labour market factors, notably outsde wages and unemployment. Our measure of market power s smply the market share of the company concerned, but as ndcators of fnancal pressure we use three varables, namely profts per employee, B/N, a flow measure of the pressure of debt, br, and a varable whch captures the extent of the shock httng the company n the recesson of (shock). To be more precse, B/N measures pre-tax profts per employee, br s a flow borrowng rato measured by nterest payments as a proporton of pre-tax profts plus nterest payments and deprecaton, and "shock" s equal to the proportonal fall n employment from for the years 1982 to 1984 and takes the value zero for other years. So ths last varable s only allowed to affect the frm for three years after the end of the recesson. The dea behnd these varables s that the frm s under more fnancal pressure, the lower are profts per employee, the hgher are nterest payments as a proporton of total avalable cash flow and the greater the shock generated by the recesson. The frst two should be lagged, snce current fnancal pressure s

17 determned by past fnancal performance. The wage equaton s based on the noton that nomnal wages are nfluenced by outsde nomnal wages and nomnal profts per employee (lagged) plus other factors. To preserve homogenety, we thus have W = (1-8)W +8(B /N ) +... t t t-j We cannot use ln(b/n) because B s sometmes negatve, so we proceed as follows. Takng dfferences yelds or )W = (1-8))W + 8)(B /N ) +... t t t-j or Addng n the other varables and ncludng a lagged dependent varable to pck-up contract related persstence, we have (21) where B /N = nomnal annual proft per employee; W = annual aggregate pay; br t = flow borrowng rato; mksh = market share; Shock = proportonal fall n employment for the years , zero otherwse; u = aggregate unemployment rate. Note that we have arranged the equaton so that the frst bracket contans the frm specfc factors arsng from market power and fnancal pressure, whereas the second bracket captures the mpact of the external labour market. The dfference form ensures that stable frm specfc factors nfluencng the level of wages are already elmnated. To mpose homogenety, we rewrte (21) as 11

18 12 (22)

19 Correspondng to ths equaton s the effort model, where the dependent varable s )RRP whch takes the value 1 f the wage settlement nvolves an agreed 6 reducton n restrctve practces and zero otherwse. In case there are systematc ndustry varatons n ths varable because of ndustry based technologcal or ndustral relatons varables, we nclude ndustry dummes (d j) as well as the varables n (22). Normalsng profts per employee on the aggregate prce level, we specfy the equaton as (23) The key hypotheses are that the frm specfc factors whch nfluence wages have the opposte effect on effort and that aggregate varables, notably unemployment, have no mpact on effort at all (* 4 = 0). An alternatve way of nvestgatng these hypotheses s smply to estmate an equaton based on (16), where we see that wages and effort have a stable negatve relatonshp at gven levels of outsde varables. Ths suggests we estmate a smple dynamc equaton of the form )(w -w ) = T + T )(w -w ) - T )RRP (24) t t t 1 t-1 t 2 t usng the lagged frm specfc varables n (23) as nstruments for )RRP. The tme effects T t capture all the relevant aggregate varables and so we are smply lookng for a negatve coeffcent on the effort term. 3. Results We shall frst brefly consder the productvty results and then turn to our man matters of nterest, namely the mpact of market power and fnancal pressure on wages and effort. Productvty results The parameter estmates of the producton functon model (equaton 19) are set out n table 1. We have a basc constant returns Cobb-Douglas equaton n column 1, followed by a CES verson n column 2. If we relax constant returns, we fnd a producton functon whch exhbts dmnshng returns and whch s not sgnfcantly dfferent from the equaton n column 1 (t=1.2). If we nclude the share of labour nteracted wth the employment term, n addton to the exstng terms, the extra varable s completely nsgnfcant. Three results are of nterest. Frst, and most mportant, lower levels of 7 restrctve practces lead to sgnfcantly hgher levels of productvty. So treatng ths as an observed effort varable seems qute sensble. Second, frms wth hgher average rents per unt of value added have lower levels of productvty growth. Note ths varable mantans ts coeffcent when average frm sze s allowed to nfluence productvty growth (column 3) whereas the postve market share effect smply dsappears, emphassng ts lack of value n a cross-secton context. So ths provdes 13

20 evdence that market power; as measured by rents accrung to shareholders, s bad for productvty growth at the frm level. Fnally, the effcency wage terms are correctly sgned and ether sgnfcant or close to sgnfcance. So ths s weak evdence n favour of such effects. Furthermore t s worth notng that f we drop observed effort (RRP) from equaton 1, the coeffcent on relatve wages rses by around 40% wth a t rato of 2.9. Ths ndcates how mportant t s to control for observed effort f we are to dentfy effcency wage effects usng the producton functon model. Wages and effort The theory of wage and effort barganng ndcates that n response to an adverse nternal shock, barganed wages wll tend to fall and barganed effort to rse, holdng constant general labour market condtons. To see f ths holds n practce, we estmate equaton (24), the results beng set out n table 2. These ndcate a strong negatve relatonshp between wages and effort n response to adverse nternal shocks (whch are used as nstruments), holdng aggregate condtons constant (va the use of tme dummes). Thus followng an ncrease n fnancal pressure, for example, frms have lower than usual pay rses and are more lkely to gan unon agreement to a reducton n restrctve practces. In table 3, we present both wage change and effort change equatons whch make clear what s gong on. The key nternal shock varables are captured by 8 changes n market share (mksh), proft per employee (B/N), the burden of nterest payments (br) and the proportonal fall n employment durng the 1979 to 1981 recesson (shock). The frst two are favourable shocks and therefore have a postve effect on wages and a negatve mpact on effort whereas the latter two varables are unfavourable and act n precsely the opposte drecton. The parameter estmates n table 3 are completely consstent wth ths story. Not all the parameters are sgnfcant but the overall pcture s compellng. Furthermore, t s clear that aggregate condtons n the labour market have a strong mpact on wages but no effect on effort, exactly as predcted by the theoretcal comparatve statc results (17, 18). Conclusons In the ntroducton we posed three questons. Our answers, based on an analyss of longtudnal data for some 66 manufacturng companes n Brtan, are as follows. Frst, our measure of ncreases n observed effort, namely agreed reductons n restrctve work practces, do lead to subsequent ncreases n productvty. Second, controllng for observed effort, there s some weak evdence that both relatve pay and aggregate labour market slack have some postve mpact on productvty. Ths s consstent wth an effcency wage story. Thrd, falls n market power or declnes n the fnancal health of companes lead to both lower pay rses and ncreases n effort (hgher chances of reductons n restrctve work practces). Ths last we see as our most robust and mportant result. 14

21 ENDNOTES 1. For example, an mprovement n the fnancal poston of a company wll reduce the rsk of bankruptcy and hence mprove job securty. For evdence on the mpact of fnancal poston on employment, see Nckell and Wadhwan (1991). 2. For example, n 1980 barganng took place over mannng levels (.e. workers per machne) as well as pay n some 80% of unon establshments (see Danel and Mllward, 1983, pp.197 and 182). However, t s worth notng that barganng over employment s very rare (Oswald and Turnbull, 1985). 3. Flexblty of workng practces nclude, for example, operatves undertakng mnor mantenance on ther machnes rather than watng for a mantenance engneer to turn up. A blatant example of nflexblty s the requrement that a "qualfed" electrcan s requred to change a lght bulb. Thus, for example, t has been noted that n some UK hosptals, the nvolvement of no less than sx employees s requred n order for a lght bulb to be replaced. 4. There are, of course, numerous studes measurng cross-secton correlatons between market structure and R and D ntensty, for example, but these are not nformatve on the man pont at ssue because they fal to control for the varaton n technologcal opportuntes across ndustres. Gerosk (1990) uses panel data and controls for the latter varable by ncludng ndustry dummes, thereby generatng relable results. 5. We were only able to match 66 companes whch had adequate tme seres data on settlements. 6. Ths s not qute correct because we adjust ths varable so that t matches the calendar year. Ths may nvolve t takng the value N, say, n one year and 1-N n the next (see data appendx for detals). Ths rules out the use of dscrete varable models (e.g. probt). 7. Note that the equaton n estmated n frst dfferences, so an agreement to reduce restrctve practces s followed by a sgnfcant ncrease n total factor productvty n the followng year. 8. Recall that the denomnator of our market share varable reflects 3-dgt ndustry sales and s not, therefore, congruent wth the approprate market. Ths makes the varable unsutable for cross-secton work but so long as 3-dgt ndustry sales are roughly proportonal to the sales n the true market over tme, then t s perfectly adequate for tme seres analyss. Snce we are takng dfferences of market share here, the results are essentally based on the tme seres varaton n the data. 15

22 DATA APPENDIX The dataset conssts of longtudnal data on 66 companes for whch we can merge nformaton from the EXSTAT company database and the Confederaton of Brtsh Industres (CBI) Pay Databank. The CBI data are avalable for and of our 66 frms, 10 are present for 5 consecutve years, 7 for 6, 8 for 7 and 41 for 8. So the panel s unbalanced. The CBI data provde nformaton on pay ncreases and reductons n restrctve practces. All the other frm specfc data come from the EXSTAT database. Frm specfc varables Output (y ). Sales (EXSTAT tem C31). Ths s normalsed on an ndustry specfc prce ndex. See below. Employment (n ). Total employment (C19). For a small number of frms (4), t s mpossble to construct a consstent total employment seres and we then use domestc employment. Captal stock (k ). Ths s based on transformng net tangble assets at hstorc cost nto the same varable at current replacement cost and then normalsng on the prce ndex for plant and machnery. Detals of the method are provded n S. Wadhwan and M. Wall (1986). Market share (mksh ). Total sales n each ndustry (TSALS) s calculated as: TSALS = N AVSALS jt j jt where AVSALS = average sales of a frm n ndustry j at year t jt N = number of frms n ndustry j n a chosen base year (1980) j The number of frms s kept constant over years to correct for the changng frm base of our sample. (The sample used to obtan these data ncludes about 1200 frms ncludng all the major quoted companes n the ndustry.) The market share s obtaned as Sales n frm n year t (EXSTAT tem C31) TSALS. jt Rent per unt of value-added (rents ). The numerator s defned as Profts before tax (C34) + Deprecaton (C51) + Interest Payments (C53+C54) - Captal Stock x (Real nterest rate + deprecaton rate + rsk premum). The real nterest rate we take to be whch s the average 1981 value of the real gross redempton yeld on 2% ndex-lnked stock (1996). The deprecaton rate + the rsk premum we take to be 4%. The denomnator s Profts before tax (C34) + Deprecaton (C51) + Interest Payments (C53+C54) + Staff Costs (C63) + Amounts payable from Proft Sharng Schemes (C72). For 1982 and after, staff costs refer to total employment and nclude socal securty and penson costs. Pror to 1982 staff costs refer to domestc wages and salares only. We have adjusted these to make them comparable to the post 1982 data. Wage ncrease ()w ). The CBI pay databank ncludes pay rse nformaton for each of up to three barganng groups. We use data on a manual barganng group. For ths barganng group, the databank provdes some nformaton on () the month of 16

23 the pay settlement, () a manager's estmate of the mpact of the settlement on the ncrease n gross average earnngs n the comng calendar year and () the actual agreed pay ncrease. In many cases () s mssng. However, when both () and () are avalable, they are nearly always the same. So we take () as our percentage pay ncrease and then use () to allocate t over the two calendar years to whch t typcally refers (the agreement s nearly always for 12 months). Reducton n restrctve practces ()RRP ). In the CBI survey of pay settlements, managers are asked whether a pay settlement also nvolved the removal of restrctve practces. The varable s a dummy whch takes the value 1 f they respond n the affrmatve. However, the settlement date s then used to allocate ths varable across the relevant two calendar years. Ths s done because the removal of restrctve practces s typcally a process lastng for at least the perod of the pay agreement, not a one-off event takng place on the settlement date. Around 38% of frms n the sample removed restrctve practces at some pont n the perod Profts (B ). Proft before tax (C34). Borrowng rato (br ). Ths s a flow concept defned as Interest Payments (C53+C54) [Profts before tax (C34) + Deprecaton (C51) + Interest Payments (C53+C54) + Constant]. The constant s set to be large enough to ensure the denomnator s always postve. We also expermented wth a stock verson of the borrowng rato, essentally debt/debt + equty), but found that the flow verson performed slghtly better. Shock. Ths s defned as -(n(1981)-n(1979)) for the years , zero otherwse. Industry level varables Unemployment rate (u ). Source: Employment Gazette. j Concentraton rato (cr ). Source: Annual Census of Producton, PA 1002, table 13. Import penetraton (mp ). Defned as mports home demand (sales + mports - j exports). Source: Busness Montor MQ12 (collected by S. Machn). Overtme hours (H ). Weekly overtme hours per operatve on overtme x fracton oj of operatves on overtme. Source: Employment Gazette. Standard hours (H ). Normal weekly hours. Source: Employment Gazette. nj Producer prce ndex (P). Source: Brtsh Busness and unpublshed data from the j Busness Statstcs Offce. Used to normalse the sales data. Aggregate varables Unemployment rate (u). Male unemployment rate. Source: Employment Gazette. Aggregate wage (w). Source: S. Savour (1989) Regonal Data , CLE Workng Paper 1135, London School of Economcs. 17

24 S)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) S)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) TABLE 1 Producton Functon (equaton 19) Dependent Varable: (yt-k t) S)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) Equaton descrpton Basc Add Independent equaton CES term varables (1) (2) *(yt-k t) 0.36 (4.3) 0.30 (2.7) *(nt-k t) 0.70 (8.7) 0.18 (1.1) H ojt/hnjt 2.24 (2.5) 1.26 (1.2) (H ojt/h njt) 0.22 (1.0) 0.22 (0.8) *(wt-1-w t-1) 0.54 (1.0) 1.27 (2.4) lnu jt (2.7) (2.1) *Rt (3.0) (2.7) 2 *(nt-k t) (2.9) Seral correlaton (N(0,1)) Instrument valdty 2 P (26)= P (25)=25.4 Notes () () () (v) (v) The number of frms s 66 and the number of observatons s 225. Absolute asymptotc t ratos n parentheses. The dependent varable s (log real sales - log real captal stock). All equatons are estmated n frst dfferences and nclude both tme dummes and 2 dgt ndustry dummes. Starred varables are treated as endogenous. Instruments nclude y (t-2,t-3,...), k (t-2,t-3,...), n (t-2,t-3,...). The equatons are estmated n frst dfferences usng the Dynamc Panel Data Package (DPD), wrtten by M. Arrellano and S. Bond and descrbed n Arellano and Bond (1991). The standard errors are robust to heteroskedastcty of general form. y = output, n = employment, k = captal, H = overtme hours, o H = standard hours, w = wages, u = ndustry unemployment rate, R = level n of restrctve practces. 18

25 S)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) S)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) TABLE 2 Structural Relatonshp Between Wages and Restrctve Practces (equaton 24) Dependent Varable: )(wt-w t) Independent varables *)(w t-1)-w t) 0.68 (17.6) *)r (3.7) t Seral correlaton (N(0,1)) 0.29 Instrument valdty 2 P (28) = 22.6 S)))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) Notes () () () (v) Number of frms s 66, number of observatons s 231. Asymptotc t ratos n parentheses. The equaton ncludes tme dummes. Starred varables are treated as endogenous. Instruments nclude n (t-2,t-3,...), )mksh t-2, )br t-2, )(B/N) t-2, shock t, 2 dgt ndustry dummes. As table 1, note (v). 19

26 S))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) S))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) S)))))))Q - S))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))))) TABLE 3 Wage and Effort Reduced Form Equatons, (equatons 22, 23) Dependent varable )(w -w ) )(w -w ) )RRP )RRP t t t t t t Independent varable *)(wt-1-w t) 0.67 (16.5) 0.64 (9.3) )ln ut (12.3) (0.3) )concjt (0.4) (0.6) (0.2) (0.2) )mksht (2.0) 0.55 (1.1) (1.0) (1.5) )(B t-2/n t-2) (4.6) (2.1) )(B /Pj N ) t (2.0) (2.0) )w t Wt *)br (3.3) (2.5) 0.71 (1.9) 0.67 (1.6) t Shockt (2.4) (0.6) 0.26 (1.8) 0.27 (1.8) Seral correlaton (N(0,1)) Instrument valdty P (23)=26.8 P (23)=25.5 Tme dummes x o x o Industry dummes x x o o Notes () Number of frms s 66, number of observatons s 231. Asymptotc t ratos n parentheses. () In columns 1, 2, the starred varables are treated as endogenous. Instruments nclude n (t-2, t- 3,...), w t-2, two dgt ndustry dummes. () Equatons n columns 1, 2 are estmated by IV usng DPD. In columns 3, 4, they are OLS (v) estmates. In all cases, the standard errors are robust to general heteroskedastcty. )w = proporton pay ncrease; )RRP = 1 f restrctve practces are removed, = 0 otherwse; ln u = log aggregate unemployment rate; conc j = ndustry concentraton rato; mksh = market share; B/N = pre-tax proft per employee; br = flow borrowng rato; shock = proportonal fall n employment for the years 1982 to 1984, zero otherwse; P = producer prce ndex. j 20

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