Human Capital and Wage Formation

Piekkola Hannu

This study uses linked employer-employee data from Finland over the period 1989-1996 to examine human capital, wage formation and its relation to firm characteristics such as high wages in large firms. The mean wage differential between plants in the 10th and 90th size classes equals 21% of the overall mean wage. R&D-intensive firms have an average 10% percent higher wages. One can show that human capital based on educational competencies cannot explain the differences. Compensations on education are transferable and widely dispersed over all firms, and the firm-size effects are modest. Unobserved human capital is less transferable. Compensations for unobserved human capital consist of high wages of the individual throughout his/her work career not explained by experience, sex or education. It is shown that unobserved human capital explains most of the higher wages in large firms. The second reason for the firm-size premium is that in large R&D-intensive firms the share of the educated workforce is  higher than in small firms. In large firms with no R&D the wage level even turns out to be no higher than average.

Why large firms pay higher wages? One internationally often proposed argument is that unwanted job seeking of employees is lower in high-wage firms, which in itself leads to large firm size. A related argument is that large firms may have a more long-standing history as a good wage payer. Therefore, high wages more convincingly lower the costly job search.

In Finland, worker mobility is, however, not lower in larger than in small firms. One argument is that large firms are prepared to hire workers at some risk, also because large part of the human capital is not directly observable. Bad performers are subsequently fired or leave the firm when not promoted. Risky workers receive an option value on good performance. Both hirings at risk and exits increase worker mobility. Indeed, non-permanent jobs are more frequent in large firms in Finland.

High wages can also work as a substitute for large monitoring costs. Small firms have more information on the worker effort of their employees and can monitor employees better than large firms. This explains why fixed-term contracts between employers and employees are more common in small firms. Firm-specific payments are indeed not higher in large firms.

It is shown that R&D-intensive firms have on average higher wages but do not pay high starting wages (except technology firms with very high R&Ds). One explanation is that by choosing to work in R&D-intensive firms employees acknowledge that they can accumulate general human capital. The wage profile is, on the other hand, relatively steep as human capital is accumulated. Hence, seniority payments are bigger in R&D-intensive firms.

It is shown that firms with high wage-earners, irrespective of firm size, earn higher profits. Another finding is that R&D transforms educational compensations into structural capital of the firm that improves profitability. In large firms a good reputation as a wage payer and the recruitment of potentially good workers at some risk are the methods by which to improve firm performance. Small firms use, on the other hand, fixed-term contracts or rent sharing. These are particularly efficient to inhibit quits of good workers.

One can see that small firms impose more flexible wages. One reason is that employers face relatively high exit costs if the employee leaves the firm. Firing of any single employee has a cost effect on the firm profitability. Raising exit costs for employers through legislation would further deteriorate the relative labour market position of small firms. Large firms with moderate R&D intensity have high wages, low worker mobility and possibly a good reputation in labour markets with no necessary shortage of labour. Higher wages ensure enough job fillings in labour market where there are large fixed costs in job search. Firings costs are less important as high wages inhibit large exits. In some large firms, as in technology firms, it is still important to have an option to get rid of bad performing high wage workers.

Publication info

ETLA B 177
25.2 €
Availability of print version