How wages are determined, and what relationship wages have with other labor market outcomes are central questions in economics. The literature on wages is extensive, dating back to Malthus’ theory of subsistence wages, and extending to modern compensation theories based on human capital, search, and incentives. A key feature, especially of the modern theories, is the dynamic aspect of wages. As a consequence wage growth ramifications are all too obvious among these theories. For example: human capital theory predicts wage growth due to on-the-job skill accumulation; job search theory predicts wage growth due to imperfect information about the location of high productivity jobs; mismatch theory predicts wage growth due to imperfect information about the match quality of jobs; and, agency theory predicts wage growth due to hiring and monitoring costs. But these theories do not explicitly ask how differences in skill accumulation or search costs or monitoring costs may give rise to permanent differences in wage growth rates among jobs, workers, or occupations. As a consequence, the role of wage growth as a predictor of other labor market outcomes is not addressed. In this paper I present a model of wage and turnover dynamics to directly address: How do wages grow over the duration of an employment relationship? Why do wage growth rates differ among jobs? Why is serial correlation of wage growth an inconclusive test of wage growth heterogeneity? What is the relationship between wage growth on a job and other labor market outcomes such as job turnover?
The theory presented here is an elaboration of job search theory and firm specific human capital theory. The key assumption in job search theory is that each worker-firm pair is characterized by an idiosyncratic (implying of course both a different and firm specific) productivity level. By contrast, my model builds on the idea that each worker-firm pair is characterized by an idiosyncratic productivity profile — that is, by both an initial productivity level and a growth function that determines future productivity on the job. Heterogeneity of productivity profiles across worker-firm pairs therefore underpins the nondegenerate distribution of jobs a worker faces in the labor market. The theory retains the salient characteristic of search, namely, the optimal assignment of workers to jobs. But unlike in traditional job search models where productivity of a worker-firm pair is static, in the model presented here the productivity of a worker-firm pair grows as the employment relationship ages. More specifically, this increased productivity is assumed to be firm specific and the rate of productivity growth to be different among jobs. Since the implications of different rates of investment in firm-specific human capital have not been fully explored in isolation before, it may explain some otherwise anomalous findings on wage and turnover dynamics.
The motivation for this paper is not only to make a contribution to the theory of wages, but also to provide an unified explanation for some recent, and more importantly, puzzling findings on wage dynamics and turnover. In the past two decades empirical studies using panel surveys of individual work histories and personnel records of large companies have repeatedly documented within-job wage increases, persistence of wage growth, and correlations between wage growth and turnover. Bartel and Borjas (1981) find evidence of positive correlation between completed tenure and within-job wage growth. In a later and more conclusive study Topel and Ward (1992) find that jobs offering higher wage growth are significantly less likely to end in worker-firm separations than jobs offering lower wage growth (holding the current wage constant). This finding not only implies heterogeneity of wage growth rates among jobs, but also that the source of wage growth must have a firm specific component.
Although the negative correlation between wage growth and turnover implies wage growth heterogeneity, the direct evidence says that jobs do not in fact differ in their prospects for wage growth. Two studies, based on the time series properties of within-job wage changes, conclude that heterogeneity in permanent rates of wage growth among jobs is empirically unimportant (Topel 1991, and Topel and Ward 1992). Note that the data of one of these studies (Topel and Ward 1992) on which this conclusion rests, are the identical data that show past wage growth on a job reduces turnover. Hence the puzzle laid out in the abstract of this paper: direct evidence says that different jobs do not have different wage growth rates despite the fact that past wage growth on a job reduces turnover.
Taken together these two findings — (1) the negative relationship between wage growth and turnover, and (2) the lack of evidence of serial correlation of wage growth — pose a challenge for accepted theory. One widely accepted theory is the “mismatch” theory of turnover. The mismatch theory says that the current wage is a sufficient statistic for job value, and hence it is consistent with studies that find no evidence of positive serial correlation of wage growth. But the mismatch theory cannot explain the negative correlation between wage growth and turnover; it predicts that separations should decline as a function of the wage level and not as a function of wage growth (Jovanovic 1979a). On the other hand, theories that simply assume heterogeneity of wage growth rates can explain the negative correlation between wage growth and turnover (Munasinghe 2000), but they are open to the objection that the evidence on wage growth persistence is inconclusive. One main objective of this paper is to provide a unified explanation of why wage growth is negatively related to turnover, and at the same time, why there is no direct evidence of serial correlation of wage growth.
