Product Market Competition, Returns to Skills, and Wage Inequality

This paper examines the effect of product market competition on firms' willingness to pay for workers of different skills and on wage inequality within an industry. Using a large panel (1982–1999) of UK workers with complete work histories, I show that returns to skill within an industry increase with competition. I identify this effect using two quasinatural experiments — that affected different sectors in different time periods — as exogenous measures of changes in competition. I investigate the mechanisms behind this relationship, and show that in addition to the indirect effects that operate through union bargaining and skill-biased technical change, there is evidence for a direct effect of competition beyond those channels. I provide an explanation for this finding based on the relationship between competition and the sensitivity of profits to cost reductions.