Mounting empirical evidence that intra-firm wage differences contribute substantially to wage inequality among identically skilled workers has renewed interest in theoretical models of the ways in which variation in firm productivity can influence worker pay.
A key question is the extent to which firms pass changes in the average labor productivity through into wages, but observational fluctuations in standard labor productivity measures are likely to reflect a number of factors that can influence wages without necessarily signaling a violation of price-taking behavior by firms.
This paper circumvents the endogeneity problem by using patent allowance decisions for ex-ante valuable patents (drawn from the set of published patent applications submitted to the US Patent and Trademark Office between roughly 2001 and 2011) as an instrument for firm-level labor productivity. Firms with initially allowed and initially rejected patent applications submitted for similar technologies in the same year are found to exhibit similar levels and trends in outcomes prior to their initial patent decision, which means that the causal effect of patent allowances on worker compensation can be estimated by comparing the two groups of firms.
Results suggest that having a top-quintile patent leads the firm to expand employment by 22% on average, and is associated with roughly $37,000 in additional revenue per worker. The patent allowance also increases average annual W2 earnings by approximately $3,700, and annual income tax revenue per worker by approximately $770. Using patent decisions as an instrument for operating surplus, the paper finds that worker earnings rise by roughly 29 cents of every dollar of patent allowance-induced operating surplus, with an approximate elasticity of 0.35. This work provides some of the first evidence that truly idiosyncratic variability in firm performance is an important causal determinant of worker pay.
Patent allowances not only raise average earnings at assignee firms, but also exacerbate within-firm inequality on a variety of margins. The paper finds that the gender earnings gap increases by roughly $6,900 (around 25%) in response to a valuation initial allowance, and that the earnings of inventors, top earning employees and employees who stay at the company also receive larger wages increases than non-inventors, lower earners, and those who leave the firm.
Surprisingly, there appears to be little effect on entry wages. This is inconsistent with the predictions of both static wage posting models and traditional bargaining models involving Nash-style surplus splitting. Instead, this finding is more consistent with the idea that firms share rents with incumbent workers to increase the odds of retaining them; using the patent decision as an instrument for wages, the researchers estimate a retention-wage elasticity of roughly 1.2. Overall, point estimates from the model imply that incumbent workers capture roughly 73% of their replacement costs in wage premia. More broadly, results suggest that the influence of firm conditions on worker wages depends critically on their degree of replaceability, which is influenced by their tenure and their position in the firm hierarchy. The fact that seniority appears to mediate the propagation of firm shocks into worker earnings even in this sample of firms strongly suggests an important role for relationship-specific investments in the generation of labor market rents.
Main articleMeasuring the extent to which firms pass changes in their performance through to worker earnings is challenging. Our work uses US patent allowance decisions as “natural experiments” that lift a company’s labor productivity. We find robust evidence that variability in firm performance is an important causal determinant of worker pay in our sample of small innovative firms. Patent allowances also exacerbate within-firm inequality in many dimensions such as between workers in the bottom and top fifths of earnings and between men and women. There is little effect on entry wages, suggesting that firms share rents from technologies primarily with incumbent workers. We interpret this rent sharing as a means of retaining crucial incumbent workers, with the precise impact depending on workers’ degree of replaceability.
Textbook models of labor markets are predicated on the price-taking assumption that firms have no power to set wages. However, there is mounting empirical evidence that intra-firm wage differences contribute substantially to wage inequality among identically skilled workers (Card, Heining, and Kline, 2013; Abowd, McKinney, and Zhao, forthcoming; Barth et al. forthcoming).
Empirical difficulties have complicated estimation of the extent to which firm productivity influences worker pay
This emerging evidence has renewed interest in theoretical models of firm wage setting that postulate mechanisms through which variation in firm productivity can influence worker pay (see Malcomson 1999; Lentz and Mortensen 2010; Manning 2011 for reviews). While a sizable empirical literature has documented that fluctuations in firm performance and worker compensation are strongly related (Card et al. 2018), these correlations are open to widely varying interpretations. Early studies (e.g., Christofides and Oswald 1992; Blanchflower, Oswald, and Sanfey 1996) estimated industry-level relationships that could simply reflect competitive market dynamics. A second generation of studies (Hildreth 1998; Abowd, Kramarz, and Margolis 1999) used firm-level data to study how shocks to firm performance translate into worker pay, but was unable to adjust for potential changes in worker composition. More recent work (Guiso, Pistaferri, and Schivardi 2005; Card, Cardoso, and Kline 2016; Lamadon 2016) adjusts for composition biases by examining the comovement between changes in firm productivity and the wage growth of incumbent workers.
A key question of interest in this literature is the extent to which firms pass changes in the ‘gross surplus per worker’ (i.e., average labor productivity) through into wages. However, observational fluctuations in standard labor productivity measures are likely to reflect a number of factors (e.g., market-wide fluctuations in product demand, changes in non-pecuniary firm amenities such as the work environment, or changes in labor market institutions) that can influence wages without necessarily signaling a violation of price-taking behavior by firms.
Using patent allowance decisions as an instrument for firm productivity can circumvent these threats to interpretation
To circumvent the problems associated with using standard labor productivity measures to look at the relationship between firm performance and worker compensation, our paper uses patent allowance decisions as an instrument for firm-level labor productivity. The analysis investigates the effect these patent allowance decisions have on worker compensation by making a link between two datasets: (i) the census of published patent applications submitted to the US Patent and Trademark Office (USPTO) between roughly 2001 and 2011 and (ii) the universe of US Treasury business tax filings and worker earnings histories drawn from W2 and 1099 tax filings.
The wage response to patent allowances is of interest for several reasons. First, patents provide firms with well-defined temporary monopoly rights that can yield a prolonged stream of potentially substantial economic rents, yet surprisingly little is known about how broadly such rents are shared with workers. Second, patent allowances fundamentally constitute firm-specific shocks. Hence, using patent allowance decisions as a source of variation in firm performance should effectively filter out market-wide wage responses. Finally, patent allowances are public and verifiable performance measures that innovative firms might plausibly incorporate into pay setting decisions. While incentive contracts are thought to be common for inventors (Holmström 1989; Aghion and Tirole 1994; Lerner and Wulf 2007; Manso 2011), there is little evidence on how important performance pay is for workers not directly involved in the inventive process.
We infer the causal effect of patent allowances on worker compensation by comparing firms whose applications were initially allowed to those whose applications were initially rejected. Our analysis suggests that these patent decisions can be treated as idiosyncratic shocks; within so-called “art units” (technological areas designated by the USPTO), firms with initially allowed and initially rejected applications submitted in the same year are found to exhibit similar levels and trends in outcomes prior to their initial patent decision. We also document that initial patent decisions are difficult to predict based on firm characteristics or geography.
It is well-known that most patents generate little ex-post value to the firm (Pakes 1986; Hall, Jaffe, and Trajtenberg 2001). To overcome that challenge, we build on insights from two recent studies to identify a subsample of valuable patents that induce meaningful shifts in firm outcomes at the time the patents are allowed. First, following the work of Farre-Mensa, Hegde, and Ljungqvist (2017), we restrict our analysis to firms applying for a patent for the first time, for which patent decisions are likely to be more consequential. This consideration is why we focus on a sample of mainly small firms, with a median of 17 employees. Second, among this sample of first-time applicants, we extrapolate the patent value estimates for publicly traded firms developed by Kogan et al. (2017) – who estimate the excess stock market return realized on the grant date of US patents assigned to publicly traded firms — to the non-publicly traded firms in our sample.
Results suggest that idiosyncratic variability in firm performance is an important causal determinant of worker pay
Initial patent allowances have no effect on the probability of firm survival, as proxied by the presence of at least one employee, but—corroborating recent research based on US Census data (Balasubramanian and Sivadasan 2011)—we find that firm size and average labor productivity rise rapidly in response to initial allowances of ex-ante valuable patents. Having a patent valued in the top fifth of the distribution leads to approximately a 22% increase in the size of the firm, and is associated with roughly $37,000 in additional revenue per worker and roughly $16,000 in value added per worker.
The average wage and salary income of workers at these firms rises in tandem with these measures of average labor productivity. An allowance of a patent application in the top quintile of ex-ante predicted value raises the wage bill per worker—defined as average earnings at the firm—by approximately $3,700 per year, and the tax revenue per worker by approximately $770 per year (+4.3%). This last finding suggests the presence of an important fiscal externality between corporate tax treatment of innovation and income tax revenue.
Using patent decisions as an instrument for operating surplus, we fit a series of “rent-sharing” specifications analogous to the cost-price pass-through specifications used to study imperfect competition in product markets (Goldberg and Hellerstein, 2013; Weyl and Fabinger, 2013; Gorodnichenko and Talavera, 2017). We find that worker earnings rise by roughly 29 cents of every dollar of patent allowance-induced operating surplus, with an approximate elasticity of 0.35. The magnitude of this wage effect is similar to the elasticity found in large UK firms by Van Reenen (1996) who also used major technological innovations to instrument for firm performance, but who was – due to data limitations — not able to control for changing workforce composition.
These estimates provide some of the first evidence that truly idiosyncratic variability in firm performance is an important causal determinant of worker pay. Given that firm productivity is highly variable and persistent (Luttmer 2007; Foster, Haltiwanger, and Syverson 2008), it is plausible that firm-specific shocks contribute substantially to permanent earnings inequality among identically skilled workers.
Patent allowances also exacerbate within-firm inequality
Patent allowances not only raise average earnings at assignee firms, but also exacerbate within-firm inequality on a variety of margins. The earnings of male employees rise strongly in response to a patent allowance, while the earnings of female employees show little response to patent decisions; amongst firms that employ both genders, we find that the gender earnings gap increases by roughly $6,900 (25%) in response to a valuation initial allowance. As shown in Exhibit 1, we also document that the earnings of “inventors”—defined as employees ever listed as inventors on a patent application as in Bell et al. (2019), rather than as individuals listed as inventors on the specific patent application relevant to a given firm in our sample—are more responsive to patent allowances (they receive an earnings increase of around $16,900) than are the earnings of non-inventors (+$2,200). Finally, earnings impacts are heavily concentrated among employees in the top quartile of the within-firm earnings distribution (+$8,100) and those listed at firm officers on tax returns (+$3,700), while bottom quartile earnings and those of non-officers are unresponsive to patent decisions. These findings strongly suggest that firms play an important role in generating earnings inequality not only across but also within workplaces.
Wages of new employees do not change, suggesting that wage increases may be best explained as a means to retain existing workers
Although the above impacts on firm aggregates could, in principle, be confounded by compositional changes, we find no evidence that innovative firms upgrade the quality of their workforce in response to patent allowances. That is, there is little evidence that the wage changes we observe are due to innovative firms changing the composition of their workforce in response to patent decisions. While patent allowances lead firms to expand by hiring slightly younger workers, the average prior earnings of both new hires and firm separators is unaffected by patent decisions, suggesting there are no major changes in the skill composition of worker inflows or outflows from the firm on a year-to-year basis.
Different theoretical frameworks offer divergent predictions about how firm-specific shocks will affect entry wages and the wages of incumbent workers. Empirically, we document that the earnings of workers who were employed by the firm in the year of application respond strongly to patent decisions. The allowance of a valuable patent raises the average earnings of these “firm stayers” by roughly $7,800—or approximately 11%—per year. These gains are widely distributed across firm stayers regardless of their position in the firm’s earnings distribution at the time of application. By contrast, we are unable to detect any response of entry wages to patent allowances, which is inconsistent with the predictions of both static wage posting models and traditional bargaining models involving Nash-style surplus splitting at the time of hiring (Pissarides 2000; Hall and Milgrom 2008; Pissarides 2009). While some dynamic wage posting models (e.g., Postel-Vinay and Robin 2002) can generate drops in entry wages in response to a productivity increase, these models predict greater wage growth for new hires, a phenomenon for which we also find no evidence.
One candidate explanation for such an “insider/outsider” distinction in earnings impacts is that the wage fluctuations of incumbent workers represent changes in market perceptions of a worker’s underlying ability (Gibbons and Murphy 1992; Holmström 1999). Such “career concerns” explanations predict that workers should be able to take some of this earnings advantage with them to new employers. However, we find much smaller and statistically insignificant earnings effects on workers who leave the firm, suggesting that our results are unlikely to be driven by public learning about worker quality.
Instead, we argue that our findings are most consistent with firms choosing to share rents with incumbent workers in order to increase the odds of retaining them. We provide evidence that heterogeneous wage effects appear to mirror heterogeneity in the costs of replacing different types of workers, and that retention rises in response to patent allowances, with larger responses among workers in the top half of the earnings distribution. The fact that groups experiencing the largest earnings responses exhibit the largest retention responses strongly suggests that the earnings fluctuations we measure constitute rents, rather than, say, risk-sharing arrangements that hold workers to a participation constraint (Holmstrom 1979, 1989). Using the patent decision as an instrument for wages, we estimate a retention-wage elasticity of roughly 1.2, with a 90% confidence interval ranging from 0.46 to 3.08.
Viewed through the lens of a model that we present in the paper, our point estimates imply that incumbent workers capture roughly 73% of their replacement costs in wage premia. We estimate that the marginal replacement cost of an incumbent worker at a firm receiving a patent allowance is roughly equal to a new hire’s annual earnings. These findings suggest that separations of key personnel can be extremely costly to innovative firms, even when these employees are not themselves inventors, and that substituting high-skilled incumbents with new hires is particularly difficult.
More broadly, our results suggest that the influence of firm conditions on worker wages depends critically on their degree of replaceability, which may be influenced by the duration of the relationship between the worker and firm and a worker’s position within the firm hierarchy, issues emphasized in recent empirical studies of wage setting at European firms by Buhai et al. (2014), Jäger (2015), and Garin and Silvério (2017). In contrast with European settings, the legal barriers to hiring and firing workers are comparatively minimal for the set of newly innovative U.S. firms that are the focus of our analysis. The fact that seniority appears to mediate the propagation of firm shocks into worker earnings even in this sample of firms strongly suggests an important role for relationship-specific investments in the generation of labor market rents.
This article summarizes ‘Who Profits from Patents? Rent-Sharing at Innovative Firms’ by Patrick Kline, Neviana Petkova, Heidi Williams, and Owen Zidar, published in The Quarterly Journal of Economics in August 2019 by Oxford University Press.
Patrick Kline is at the University of California, Berkeley. Neviana Petkova is at the US Department of Treasury. Heidi Williams is at Stanford University. Owen Zidar is at Princeton University.