Dynamic Wage Setting: The Role of Monopsony Power and Employment Costs

We develop and estimate a model of dynamic wage setting that jointly identifies latent worker ability, firm productivity, and wage markdowns, defined as the ratio of wages to the marginal revenue product of labor. Using matched employer-employee data and firm accounts, we document that markdowns widen with average worker ability and firm productivity. We decompose markdowns into a static monopsony wedge, determined by the firm-level labor supply elasticity, and a dynamic cost wedge reflecting non-wage employment costs and the continuation value of labor. Static monopsony power accounts for most of the average level of markdowns but explains very little of their cross-sectional variance. Nearly all dispersion in markdowns arises from the dynamic cost wedge. Standard wedge-accounting exercises that treat observed markdowns as measures of employer market power would misattribute most of the within-market markdown dispersion to the wrong source.

Working Paper.
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