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The Fallacy of Composition Bias in the RealWage Cyclicality Puzzle

  • Cyrus Farsian

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    Composition bias in aggregate wages is often a scapegoat for the apparent unresponsiveness of wages over the cycle. Since Bils (1985) and in particular Solon et al. (1994), who find that that real wages are highly pro-cyclical a general consensus has emerged that the observed ‘mild’ cyclicality in real wages is due to composition effects which cause counter-cyclical biases because low wage jobs are the first to be destroyed during recessions (Pissarides, 2009). In this paper, it is argued that the results of Solon et al. (1994) and other papers using similar techniques cannot possibly disentangle the true effect of composition bias. This is because the assignment of fixed weights used to keep the composition of the work force constant is arbitrary and imposes a particular direction to the bias. Thus, rather than determining the bias it only serves to show the possible magnitude once having assumed the way the bias works. As in Blundell et al. (2003) we can unravel the bias into three interpretable parts. That is biases due to individual movement in and out of work, changes in the variation of hours worked and changes in the variance of wages over the cycle. The findings show that aggregate real wages become cyclically less responsive over the cycle and no evidence of ‘counter-cyclical’ composition bias.

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    File URL: ftp://ftp.ukc.ac.uk/pub/ejr/RePEc/ukc/ukcedp/1116.pdf
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    Paper provided by School of Economics, University of Kent in its series Studies in Economics with number 1116.

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    Date of creation: Oct 2011
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    Handle: RePEc:ukc:ukcedp:1116
    Contact details of provider: Postal: School of Economics, University of Kent, Canterbury, Kent, CT2 7NP
    Phone: +44 (0)1227 827497
    Web page: http://www.kent.ac.uk/economics/

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    1. A Gosling & Stephen Machin, 1995. "The Changing Distribution of Male Wages in the UK," CEP Discussion Papers dp0271, Centre for Economic Performance, LSE.
    2. Neftci, Salih N, 1978. "A Time-Series Analysis of the Real Wages-Employment Relationship," Journal of Political Economy, University of Chicago Press, vol. 86(2), pages 281-91, April.
    3. Ulrich Woitek, 2004. "Real Wages and Business Cycle Asymmetries," CESifo Working Paper Series 1206, CESifo Group Munich.
    4. Richard Blundell & Mike Brewer & Marco Francesconi, 2005. "Job changes, hours changes and labour market flexibility: panel data evidence for Britain," IFS Working Papers W05/12, Institute for Fiscal Studies.
    5. Keane, Michael & Moffitt, Robert & Runkle, David, 1988. "Real Wages over the Business Cycle: Estimating the Impact of Heterogeneity with Micro Data," Journal of Political Economy, University of Chicago Press, vol. 96(6), pages 1232-66, December.
    6. Richard Blundell & Howard Reed & Thomas M. Stoker, 2003. "Interpreting Aggregate Wage Growth: The Role of Labor Market Participation," American Economic Review, American Economic Association, vol. 93(4), pages 1114-1131, September.
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