The role of firms in explaining pay differentials is well documented. At the same time, there is growing evidence that market power of employers is substantial and widespread across countries. This column uses detailed Social Security data for Lithuania over two decades to bridge these two lines of evidence. The analysis suggests that wage inequality may partly emerge as a market failure: greater competition in the labour market among firms can lead to lower earnings differentials among workers. It provides suggestive evidence that the 2004 EU accession catalysed labour market competition among Lithuanian firms.
Income inequality dominates economic and political debates around the world. Although returns to capital, whether tangible or intangible, shape the distribution of income at the top, for millions of people around the world it is how their work is rewarded in the labour market that matters (Hoffmann et al. 2020). While it is well-documented that labour earnings differ for workers with different skills, occupations, or genders, recent literature has emphasised that firms (where individuals work) are critical determinants of income gaps (Card et al. 2018).
The theory of wage determination suggests that the contribution of firms to workers’ earnings is closely related to the degree of market power of employers (Manning 2003). In other words, if firms’ labour supply curves are far from perfectly elastic, employers with market power will be able to set wages below their competitive level – the marginal revenue product of labour. This might lead to a degree of wage dispersion above the level predicted by a model of perfect competition (Deb et al. 2024).
In a recent paper (Garcia-Louzao and Ruggieri 2025), we use Lithuanian Social Security data to examine the dynamics of labour market competition among employers and the dispersion of earnings among workers. Lithuania provides a useful laboratory for at least two reasons. Over the past 20 years, worker compensation has increased dramatically (Figure 1a). At the same time, earnings inequality has declined significantly (Figure 1b). Specifically, the variance of log daily earnings fell by about 20 log points.
Figure 1 Labour income dynamics
In this column, we first document how firms contribute to cross-sectional wage dispersion in Lithuania and how this has evolved during the country’s economic development. Next, we analyse changes in the labour supply elasticity to firms — a key indicator of labour market competition (Manning 2021). Finally, we explore how these two trends have co-evolved and present suggestive evidence that the 2004 EU enlargement may have been a driving factor behind both phenomena.
Workers and firms in the variance of wages across countries
Figure 2 reports the contributions of workers and firms to earnings inequality obtained from two-way fixed effects models (Abowd et al. 1999). In about 20 years, Lithuania has jumped up the development ladder and its wage dynamics have moved from those of low-income countries to those of high-income countries. Therefore, we compare the case of Lithuania in the early 2000s and in the late 2010s with selected countries using available estimates from the literature.
Figure 2 The contribution of firms and workers to inequality
On the one hand, the Lithuanian economy in 2000-2005 had the largest contribution of firms in explaining the variance of wages (38%), a value comparable only to Mexico in 2014-2018 (37%) and followed by South Africa in 2011-2016 (35%). On the other hand, the contribution of firm heterogeneity to wage dispersion falls to around 20% in 2015-2020, a value closer to the cases of Germany in 2002-2009 and Brazil in 2010-2014. These figures are still higher than those of the US (2007-2013) and France (2014-2019), where the dispersion of firm fixed effects contributes less than 10% to wage dispersion.
Turning to the quantification of the contribution of workers and firms to the change in inequality, we find that the change in the dispersion of the firm fixed effects is the main channel behind the decline in inequality, explaining between 64% and 93% of the total change.
Labour market competition and inequality
In the second part of the analysis, we characterise the evolution of employers’ labour market power. To do so, we follow a widely used approach and identify the elasticity of job separation to firms’ pay. We then use the separation elasticity to construct the firm’s labour supply elasticity (Manning 2003). Our estimates indicate that the level of the labour supply elasticity to the firm was about 25% higher in 2015-2020 than its initial value in 2000-2005, suggesting an increase in labour market competition. This trend resembles the evidence reported in Ding et al. (2024) on the decline in wage markdowns in Lithuania estimated using the production function approach.
Independently, our results point to a decline in firm-driven wage inequality accompanied by increased competition in the labour market. Thus, we exploit cross-sector variation to correlate changes in the elasticity of labour supply to the firm with changes in the dispersion of firm-specific wage components between 2000 and 2020. The raw correlation between the two variables suggests a negative gradient between changes in labour market competition and firm-level inequality. In other words, the sectors in which competition in the labour market has increased the most exhibit the largest declines in the dispersion of firm-specific wage components. A back-of-the-envelope calculation using our estimates suggests that the implied change in inequality driven by the dynamics of labour market competition could be roughly 17%.
In our analysis, we provide suggestive evidence that the 2004 EU accession likely catalysed labour market competition among Lithuanian firms. By 2020, over 15% of Lithuania’s population was working abroad, with two-thirds in EU countries. This mass emigration, which accelerated after EU accession, tightened the domestic labour market and likely reduced wage inequality by expanding job opportunities for Lithuanian workers. Notably, we find that sectors in EU countries with the largest expansions in labour demand correspond to sectors in Lithuania that experienced the greatest increases in labour supply elasticities and the strongest compression of firm pay inequality. Through the lens of the canonical monopsony model, EU accession plausibly contributed to this decline in wage inequality by increasing labour supply elasticity to firms and reducing employer market power.
Conclusion
Like other countries that have experienced similar dynamics of earnings (Alvarez et al. 2018, Silva et al. 2022), we document that the decline of wage inequality in Lithuania is largely explained by a reduction in the dispersion of firm-specific wage premia. More importantly, we show that the dynamics of wage inequality are related to competitive forces: changes in labour market competition imply a fall in inequality of about 17%. Overall, our analysis provides empirical support for the idea that earnings inequality may arise from market failures (Deb et al. 2024), and it suggests that strengthening the position of workers in the labour market can help reduce wage dispersion and increase welfare.
Source : VOXeu
