Wage Setting and Passthrough: The Role of Market Power, Production Technology and Adjustment Costs

Abstract

How much do adjustment costs, labor market power and production complementarities matter for wage setting and passthrough? We develop a general theoretical framework and empirical identification strategy illustrating how firm productivity impacts wages in imperfect labor markets. We estimate firm-level distributions of productivity, worker ability, markdowns, passthrough and labor-supply elasticities using Danish data. Typical firms respond to 1% productivity increases by lowering markdowns 1.7% and increasing marginal productivity 2.1% — increasing wages by 0.4%. Adjustment costs induce firms to hoard workers and increase markdowns in response to negative shocks. Labor market power and adjustment costs reduce passthrough, decreasing wage volatility by 77%.

Keywords: TFP, Productivity, Passthrough, Wage Setting, Imperfect Competition, Markdowns, Market Power, Monopsony, Adjustment Costs, Income Risk

JEL Classification: E2, J2, D24, J42