Wage Inequality and Firm Performance: Professional Basketball's Natural Experiment

By Berri, David J.; Jewell, R. Todd | Atlantic Economic Journal, June 2004 | Go to article overview

Wage Inequality and Firm Performance: Professional Basketball's Natural Experiment


Berri, David J., Jewell, R. Todd, Atlantic Economic Journal


A Natural Experiment from Professional Basketball

An issue highlighted in the National Basketball Association's (NBA) 1998-99 labor strife was the disappearance of the league's middle class. While a few athletes had garnered the attention of the media for contracts in excess of 100 million dollars, a larger number of veteran players were playing at the minimum wage, albeit NBA style. (1) The changes in salary equity were primarily a result of the 1995 collective bargaining agreement (CBA). (2) Not only did this agreement increase the team payroll cap by 45 percent, it also eliminated the institution of restricted free agency. Hence, all players without a contract at the conclusion of the 199596 season were free to negotiate and sign with any team in the NBA. As a result, several organizations began the summer of 1996 with relatively empty rosters and significant amounts of money to spend on the acquisition of talent. The path taken by many of these teams was to devote a substantial amount of team payroll to a few star players. The remainder of the roster was then filled with players only offered the NBA minimum wage. (3)

Although the salary trends observed in the 1990s were clearly not welcomed by a significant portion of the athletes employed by the NBA, such rapid changes in the distribution of salaries represent a natural experiment for economists wishing to understand how changes in pay inequality impact worker performance. Given that basketball is a team sport where cooperation among workers would appear critical for team success, how do increases in wage disparity impact firm performance?

The Answer from the Literature

The Theoretical View

The answer to this question from economic theory, as with much of economics, depends upon the writer consulted. On one hand, there lies the pay compression school. Proponents from this school [Milgrom and Roberts, 1988; Akerlof and Yellen, 1988; Akerlof and Yellen, 1990; Levine, 1991; Lazear, 1989 and 1991] argue that relative wage equality will enhance worker cooperation and hence, firm performance.

Of course, one hand, as any good economist knows, is not enough to answer any question. On the other hand, there lies the view that increases in wage disparity can actually improve firm performance. The work of Ramaswamy and Rowthorn [1991] suggests that a firm should offer greater wages to workers whose shirking or similar behavior can dramatically reduce firm output. A similar story can be told from the perspective of tournament theory [Lazear and Rosen, 1981; Rosen, 1986]. Like the damage potential story, tournament theory suggests that pay inequality results in higher worker productivity. Workers near the bottom of the firm's hierarchy are paid a wage less than their marginal revenue product (MRP). The workers accept relatively low wages in the hope of securing a position at the top of the firm's hierarchy, a position that offers a wage in excess of the worker's MRP. In essence, significant pay inequality indicates that workers are competing in a tournament, the purpose of which is to elicit higher productivity from labor.

The Empirical View

The view one takes regarding the link between wage inequality and firm performance depends crucially on the theoretical hand one consults. Does the empirical evidence favor either approach?

Empirical investigations into the link between the structure of pay and firm performance have been conducted in a variety of sport and non-sport settings. With respect to the latter, one is referred to the work of Main, O'Reilly, and Wade [1993], who offered a study of executive compensation; Knoeber and Thurman [1994], who examined contract growers of broiler chickens; and Ericksson [1999], who examined executive compensation with Danish data. Each of these studies offered evidence that wage inequality was consistent with improved firm performance.

A variety of sports have also been previously examined with less consistent results. …

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