Firm‐Size Wage Gaps along the Formal‐Informal Divide: Theory and Evidence

• Author: Binnur Balkan,Semih Tumen
• Published date: 01 April 2016
• DOI: http://doi.org/10.1111/irel.12135
• Date: 01 April 2016

Firm-Size Wage Gaps along the Formal-Informal

Divide: Theory and Evidence*

BINNUR BALKAN and SEMIH TUMEN

Observationally equivalent workers are paid higher wages in larger firms. This

fact is often called the “firm-size wage gap”and is regarded as a key empiri-

cal puzzle. Using microlevel data from Turkey, we document a new stylized

fact: The firm-size wage gap is more pronounced for informal (unregistered)

jobs than for formal (registered) jobs. To explain this fact, we develop a two-

stage wage-posting game with market imperfections and segmented markets,

the solution to which produces wages as a function of firm size in a well-

defined subgame-perfect equilibrium. The model proposes two explanations.

First, taxes on formal employment generate a wedge between formal and infor-

mal size wage gaps. Thus, government policy can potentially affect the magni-

tude of the firm-size wage gaps. The second explanation features a market-

based framework with strategic interactions. Relative to small firms, large firms

typically post higher wages for both formal and informal jobs. A high-wage

formal job attracts a larger pool of applicants than a high-wage informal job.

The larger pool of applicants for the formal job, in turn, allows the firm to

somewhat lower the initial wage offer, while this second-round effect is negli-

gible for informal jobs. As a result, size differentials are lower in formal jobs

than informal jobs. We argue that the observed patterns in the use of social

connections in job search and heterogeneity in job preferences can be used to

justify the validity of this second mechanism.

*The authors’affiliations are, respectively, Central Bank of the Republic of Turkey, Ankara, Turkey.

E-mail: binnur.balkan@tcmb.gov.tr; Central Bank of the Republic of Turkey, Ankara, Turkey, and IZA,

Bonn, Germany. E-mail: semih.tumen@tcmb.gov.tr.

The authors thank Daron Acemoglu, Matteo Bobba, Kerem Cosar, Hakan Ercan, Ercan Uygur, seminar

participants at the Central Bank of the Republic of Turkey, the participants of the Turkish Economic Associ-

ation Workshop on Economic Statistics in Ankara, BETAM/World Bank Labor Market Network Meeting in

Istanbul, International Economic Association Conference in Dead Sea/Jordan, IZA/World Bank Conference

on Employment and Development in Lima, and Turkish Economic Association Conference in Antalya for

useful suggestions. They are particularly grateful to Kitt Carpenter (the editor) and two anonymous referees

for very helpful comments. The views expressed here are their own and do not necessarily reflect those of

the Central Bank of the Republic of Turkey. All errors are the authors’.

JEL: C78, J21, J31, L11.

INDUSTRIAL RELATIONS, Vol. 55, No. 2 (April 2016). ©2016 Regents of the University of California

Published by Wiley Periodicals, Inc., 350 Main Street, Malden, MA 02148, USA, and 9600 Garsington

Road, Oxford, OX4 2DQ, UK.

235

Introduction

It is well documented in the literature that larger firms pay higher wages to

observationally equivalent workers than do smaller firms.

1

This fact holds

almost invariably across countries and sectors as well as across jobs with dif-

ferent supervisory responsibilities.

2

Several explanations are offered in the lit-

erature ranging from unobserved worker heterogeneity (Idson and Feaster

1990) to unobserved firm productivity (Idson and Oi 1999) and from the need

for better data (Troske 1999) to firm-level differences in labor turnover due to

differences in hiring and human resource management practices (Idson 1996).

Still, the firm-size wage gap is regarded as one of the key empirical challenges

in labor economics and additional research is called for to enhance our under-

standing of this observed phenomenon.

In this paper, we document a new fact: The firm-size wage gap is higher for

informal jobs than formal jobs. We perform our empirical analysis using a

nationally representative microlevel dataset from Turkey, which we believe is a

good laboratory in which to study this question because around 25 percent of all

jobs are informal. “Size”corresponds to the number of workers employed in a

particular firm. The data allow us to define firm size in six categories, 1 being the

smallest and 6 being the largest. After controlling for a comprehensive set of

observed covariates, we find that the wage gap between the firms of the largest

versus the smallest size (i.e., Size 6 versus Size 1) is 33.2 percent and 46.7 per-

cent for formal and informal jobs, respectively. This means that the average pay

differential between the largest and the smallest firm is approximately 14 percent

higher in informal jobs than in formal jobs. Moreover, this difference increases

monotonically—from 0 to 14 percent—as size increases from 1 to 6; that is,

when we consider wages as a function of size, our finding means that the slope

of this function is steeper for informal jobs than formal jobs. (See Figure 1 for a

clear empirical visualization of this statement.)

To answer the question of whether it is possible to develop a coherent theo-

retical framework to understand the forces driving this result, we construct a

two-stage wage-posting game with market imperfections and segmented

markets. The solution of this game analytically characterizes wages as a func-

1

See Oi and Idson (1999) for a comprehensive review of the early literature. Breakthrough papers in

the early literature that deserve attention include Mellow (1982), Brown and Medoff (1989), and Groshen

(1991).

2

For studies documenting firm-size wage gaps at the country level, see, for example, Marcouiller, Ruiz

de Castilla, and Woodruff (1997) for El Salvador, Mexico, and Peru; Tan and Batra (1997) for Colombia,

Mexico, and Taiwan (China); Brunello and Colussi (1998) for Italy; Hollister (2004) for the United States;

and Lallemand, Plasman, and Rycx (2007) for Belgium, Denmark, Ireland, Italy, and Spain. Baker, Jensen,

and Murphy (1988) document sectoral differences in size-wage gaps for CEOs. Meagher and Wilson (2004)

and Fox (2009) find that the size-wage gap is larger for jobs with managerial responsibilities.

236 / BINNUR BALKAN AND SEMIH TUMEN

tion of firm size within a well-defined subgame-perfect equilibrium. Firms dif-

fer in size, but workers are homogeneous. Each firm posts a wage, workers

observe all offers, and devise a symmetric application strategy. Large firms

offer higher wages, because the vacancies posted by them are more valuable—

as larger firms are more productive. This framework proposes two mechanisms

PLOT OF THE ESTIMATES

0%

10%

20%

30%

40%

123456

Wage Gap

Firm Size

Formal Informal

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

123456

Differential Wage Gap

Firm Size

FIGURE 1

PLOT OF THE ESTIMATES

NOTE: The upper panel describes the firm-size wage gap relative to Size 1 for both formal and

informal jobs. For example, a typical formal job at a Size 4 firm pays 17 percent

exp 0:157½1ðÞ100 more than a formal job at a Size 1 firm, while this gap is 26.2 percent

exp 0:233½1ðÞ100 for a typical informal job at a Size 4 firm. The red dashed lines are

simply reference lines indicating the slope differential between the two black lines. To make

this differential more concrete, the lower panel plots the vertical distance between the two lines

in the upper panel. See Table 1 for the exact numbers used to construct the plots.

Formal and Informal Firm-Size Wage Gaps / 237