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While falling unemployment continues to be a positive economic development across the world, it has coincided with an alarming slowdown in wage growth which is having damaging impacts on living standards. We explore some of the major forces behind this wage stagnation – namely uncompetitive labour markets, the rise of outsourcing, technological change and automation.

What is causing wage stagnation?

Since the financial crisis, real wage growth has slowed considerably compared to the levels seen during the pre-crisis period, more than halving from an average of 1.5% a year to 0.7% (see Figure 1). However, the fact that this stagnation has been accompanied by record low levels of unemployment has puzzled economists.

Traditional mechanisms – whereby high levels of employment were associated with rising wages as companies increased pay to retain staff and offered higher salaries to attract new employees – no longer seem to apply (see Figure 1).

Recent research has pointed to a potential culprit; the increased concentration of firms, particularly in local labour markets, which reduces competition amongst hiring firms. This, alongside the increased prevalence of ‘non-compete’ and ‘no-poach agreements’, the growth of outsourcing, globalisation and automation have placed downward pressure on wages.

Uncompetitive labour markets

The classic example of an uncompetitive labour market – or to give it its technical term, ‘monopsony’ – is a mining town. Here, a single firm – the mine – is the sole employer, giving the owner the ability to set the wages of those employed.1. Although less extreme today, the increased concentration of firms in some labour markets, and the lack of alternative opportunities, have been shown to place downward pressure on wages.

Local labour markets matter. High housing costs, family responsibilities, job-specific knowledge and the costs associated with the search for new opportunities limit worker mobility.2. Therefore, while national labour markets are relatively competitive, recent research suggests that there are high levels of firm concentration in the average local labour market, and this matters to a significant proportion of individuals. This concentration means there are fewer firms competing for labour, giving these firms wage-setting power, with this concentration higher in developing countries.3. In the US, moving from a location which had a low concentration of employers in a given occupation, to a high concentration area, was estimated to cause a 17% decline in wages.4.

Further research in the UK and the US finds that greater levels of labour market concentration are linked not only to lower wages, but also to a fall in employees’ share of business productivity growth.5. Historically, the splitting of productivity gains between employee and employer ensured that wage growth closely tracked productivity growth. However, recent evidence has suggested that the employees’ portion is shrinking, with the greatest falls in the most concentrated industries. This implies that growth is less inclusive in these concentrated markets, as workers receive a falling proportion of what they produce.6.

“In contrast, by limiting workers’ employment mobility and prospects through use of ‘non-competes’ and ‘non-poach agreements’, employers are curtailing the spread of entrepreneurship and innovation.”

Against this backdrop, it is unsurprising that wages have stagnated across many advanced economies.7. The story, however, doesn’t end there. Several recent legal cases have shone new light on the practices that employers are using to reduce worker mobility. ‘Non-compete agreements’, once the preserve of top company executives or those with insider knowledge, by 2014 affected no fewer than one-in-five US workers.8. In states where such agreements are enforceable, wages have been found to be 4% lower than in non-enforcing states.9.

But non-competes are not the only mechanism through which worker mobility can be constrained. In 2015, Adobe, Apple, Google and Intel agreed a settlement of almost $500 million for their part in an agreement not to poach each other’s software developers. These ‘no-poach agreements’ stymied wage growth by limiting an employee’s ability to move, or threaten to move to another firm, thereby lowering their bargaining power in negotiations with employers. Had these ’no-poach agreements’ not been in place, it is estimated that the 64,000 affected workers could have earned an additional $3 billion – almost $50,000 per worker – over the period of the agreements.10.

In the short term, limiting an employee’s ability to change employer allows companies to retain their most talented staff, prevents sensitive information being obtained by a competitor – which may affect a firm’s competitive standing – and allows firms to stifle wage growth. However, worker mobility, in the long run, can be beneficial for businesses. It has been suggested, for example, that one key element of Silicon Valley’s success in the tech sector is California’s effective ban on non-compete agreements.11. By allowing workers to change firms, or start their own, know-how and innovation spreads and competition increases, with potential productivity-enhancing effects.

In contrast, by limiting workers’ employment mobility and prospects through use of ‘non-competes’ and ‘non-poach agreements’, employers are curtailing the spread of entrepreneurship and innovation. Restricting competition within the labour market gives them a degree of wage-setting control they may not have otherwise had, but the knock-on effects may be negative for them as well as workers.

The rise of outsourcing

‘Monopsony’ and restricting labour market competition artificially are evidently playing a role in this recent puzzle, with monopsony power found to be greater in recessionary periods.12. The problem of wage stagnation cannot, however, be viewed through a single lens. Another key factor is the so-called ‘fissuring’ of workplaces.13. Fissuring relates to the way in which the boundary of the firm and hiring has evolved in recent years. Where previously a large firm might have directly employed an IT support, a catering and a customer service representative, today they instead rely on external agencies and contractors for non-core services.

By outsourcing work, a large firm can rely on competition between service providers to ensure costs are low. However, this means those employed at the external firm may lose out. Working norms once dictated that lower-skilled workers receive pay rises alongside the more highly skilled core workers but now, detachment means employees receive a smaller cut as competition squeezes margins at outsourced service providers.

Evidence from Germany and the US confirms this, with outsourcing being attributed to a 10% and 3% reduction in wages, respectively.14. Data for Brazil, Japan, Sweden and the UK also suggests that in recent years, increases in inequality have been driven by greater wage inequality between firms, not by wider distribution of wages within a firm. This pattern points, at least in part, to greater outsourcing.15. Importantly, this rise in wage inequality will be observed as wage stagnation when the average worker sees little change in their wages.

Both monopsony and fissuring are connected to the growth of ‘superstar’ firms (Figure 2). These firms, or small groups of firms, have large market shares, superior productivity to their competitors, and are often highly specialised, dominating industries in many developed nations.16.17. The obvious examples are high-tech firms such as Facebook or Snapchat, whose supremacy stems from the network effects associated with communication technologies, i.e. the fact that each additional user increases the value of the technology to all other users. After all, there’s no point in being on a social network if your friends aren’t. Beyond technology, there are other obvious examples of superstar firms; major pharmaceutical firms such as GlaxoSmithKline and Sanofi, and well-known consumer goods businesses such as Walmart and CocaCola.18.

These firms are more productive than their counterparts and can offer the low-cost, high-quality products that consumers desire. To maintain their high levels of productivity, the firms continue to concentrate on core competencies, resulting in rising levels of outsourcing and rising wage inequality. Low costs allow superstar firms to gain even more market share which results in industries becoming more concentrated. This grants these firms market power in both the product and labour markets, giving them the power to potentially set prices and wages.

Automation and globalisation

Work by the International Monetary Fund (IMF) suggests that in advanced countries 50% of the decline in the labour share, which is closely linked to wage stagnation, can be attributed to technology, whilst a further 25% is credited to globalisation.19.

In recent years, the cost of investment goods has fallen steeply whilst technological improvements have made routine – and increasingly non-routine – tasks vulnerable to automation. These complementary forces increase the incentive for firms to substitute capital for labour, shedding jobs in the short run and shifting bargaining power in favour of the employer.

This places downward pressure on wages, with a recent influential paper finding that one extra robot per 1,000 workers lowers wages by between 0.25 and 5%.20.

The limited numbers of robots installed in many countries relative to the best performer, Singapore, suggests that this is likely to place further downward pressure on wages in years to come (Figure 3). The lower cost of information and communication technologies (ICT) has increased the internationalisation of firms’ supply chains. Global supply chains split a production process into individual tasks with the optimal production location chosen for each task. The choice of optimal location will depend on quality concerns, speed to consumer requirements or cost minimisation. For labour-intensive processes, optimal locations are typically those where wages are low relative to developed economies. The threat of potential offshoring further reduces the bargaining power of labour pushing down wages and conditions.

Potential responses

Wage stagnation is a major concern for workers and policymakers alike. It affects the purchasing power of consumers, which in turn reduces consumer demand or induces individuals to increase personal borrowing to maintain living standards. Whilst globalisation and automation remain the key structural factors leading to wage stagnation, firm market power and pervasive outsourcing are exacerbating them.

Life-long education and reskilling programmes should be a priority for governments and firms facing these issues. By developing skillsets which are less vulnerable to the forces of outsourcing, automation and globalisation, such as basic computer and coding knowledge, as well as creative and critical thinking, the skew in bargaining power towards the firm can become less extreme, alleviating some of the downward pressure on wages.21. The boost to workers’ human capital from training will also increase productivity which should in turn stimulate wage growth.

The rise in firms’ labour market power suggests that anti-trust agencies should increasingly seek to identify excessive market power both on the supply and the demand side of the market, taking appropriate action when breaches are observed. In particular, it has been suggested that this should form a key part of analysis when assessing the societal impact of mergers.22.

More broadly, the greater use of technology in the workplace has, in recent years, increased opportunities for flexible working, tying workers less to their relatively concentrated local labour market and enabling them to benefit from more geographically distant opportunities. Such policies are also advantageous for businesses, enlarging their pool of candidates and improving the match of candidates and vacancies. To have a transformative effect, however, these technological solutions must be adopted more broadly, and employees actively encouraged to take advantage of them.