For a long time, economists believed that inequality in the labor market could be explained fundamentally by differences in skills. Workers who were highly educated, experienced and skilled tended to be rewarded better by the labor market than workers who weren’t. Firms were essentially irrelevant in this paradigm. Workers were rewarded for their productivity: It didn’t matter what firms employed them.
That paradigm has now shifted. Over the last 20 years, economists have come to accept that workers of the same skill level may be paid very differently because they work in different kinds of firms. Yet, it is only in the last decade — and even more recently in Latin America — that economists have had the tools to quantify and document firms’ role in inequalities’ dynamics.
The widespread drop in inequality
It is precisely the existence of those new tools that help us explain how wage inequality in the region fell in the 2000s. That decline was significant. As Joana Silva and I document in our recent book, Wage Inequality in Latin America, inequality decreased in 16 of 17 countries analyzed, with especially large reductions in the commodity exporters of South America. Declining gaps in pay between low- and high-skilled workers made a difference — the result of numerous factors including higher demand for low-skilled workers during the commodity boom and increasing supply of better educated and more experienced workers. But those factors were far from the whole story. In fact, as we detail in the book, more than half of the inequality reduction occurred not between low and high-skilled workers but among workers with the same level of skill working at different companies.
What could be behind shrinking differences in pay among workers with the same skills? We were able to disentangle the different factors because of the very recent availability of the new tools: records from social security administrations that allow researchers to track both workers and firms across their lifetimes. For researchers in developed countries like Germany and the United States, these records have become available as social security administrations have found ways to keep the names of workers and firms anonymous while still supplying the vital information. In parts of Latin America, that process has occurred only in the last three or four years. But fortunately it is taking place and more data is becoming accessible.
Documenting changes in inequality among firms
In recent research, Joana Silva and I update and expand on the findings of the book. Using the social security information for two South American commodity exporters in which wage inequality shrank dramatically — Brazil and Ecuador — as well as information on Costa Rica, where inequality increased, we were able to document the changes in wage inequality among firms. In Costa Rica, the differences in pay among firms widened. Meanwhile, in Ecuador, and even more so in Brazil, the differences in pay among firms declined during the 2000s. We believe we know — though it remains a hypothesis — why that happened.
As commodity exports boomed, money poured into Brazil and Ecuador. Individuals, businesses and governments went on a spending spree. Local currencies appreciated. As a result, the economies’ most productive firms — the manufacturers that sold abroad and paid the highest wages — found it difficult to export. That meant some of them downsized, shedding workers into other parts of the economy where wages were lower, or simply stopped paying such high wages to their employees. This meant the large difference in salaries between the manufacturing exporters and the less productive manufacturers limited to the domestic market shrank, reducing wage inequality among workers. A similar process occurred between service-related firms that exported and those that didn’t, also leading to compression of wage differences.
Growing inequality in Costa Rica
In Costa Rica, meanwhile, a net commodity importer, rather than exporter, the opposite happened. Wage inequality actually increased, both as a result of widening gaps between low and high-skilled workers and among firms – a dynamic similar to that experienced recently in the United States and other developed economies. Costa Rica is our only case study in the region where that happened, and it is thus difficult to know why. But as one of the most technologically advanced countries in Latin America, technological factors similar to other developed countries likely played a role in widening inequality there.
Much research still needs to be done, not least to determine whether the reductions in wage inequality have persisted despite the economic downturns in the region in recent years. Latin America remains the world’s most unequal region apart from sub-Saharan Africa. Yet while inequality has soared in numerous areas of the developed world, including the United States, it appears to have fallen in Latin America. We now have the tools to document both how changes in firm composition — as well as changes among workers — made the difference.