Wage Growth and Inequality Change During Rapid Economic Transition
Ira N. Gang
Department of Economics, Rutgers University
Robert C. Stuart
Department of Economics, Rutgers University
Department of Economics, Tulane University
February 4, 2006
East Germany, a unique socialist command economy prior to the 1990s, underwent rapid transition
to a market-oriented economic system. This transition has been of intense interest given the
environment of Eastern Germany vis-a-vis Western Germany, a setting different from most other
transition economies. However, changes in the Eastern wage structure during transition demonstrates
considerable similarity to that occurring in other transition economies. During the course of this
transition, East Germany experienced big increases in both its wage level and wage dispersion. From
1990 to 2000 real wages in East Germany for men aged 20-60 rose by 118%, while various
inequality measures indicate an increase in wage inequality of 25 to 61%. This paper studies the
causes of this growth in wages and the changes in wage inequality, the first two moments of the
wage distribution. We find that changes in the wage structure due to the transition explains most of
wage growth and inequality change in East Germany. Most of the increases occur at the beginning
of the transition. We compare our 1990-2000 results for East Germany to West German wage earners
during the same period in order to investigate whether convergences took place in terms of mean
(level) and dispersion (inequality).
JEL codes: D30, J30
Keywords: decomposition analysis, wages and inequality, earnings equation, coefficients (price)
effect, characteristics (quantity) effect, residuals effect, transition
*Part of this work was done while Myeong-Su Yun visited the Department of Economics, Rutgers
University. Thanks are due Elizabeth Brainerd for helpful comments on an earlier draft.
Correspondence: Ira Gang, Economics Department, Rutgers University, 75 Hamilton St, New
Brunswick NJ 08901-1248 USA.
East Germany (the former German Democratic Republic or GDR) underwent rapid transition
from a socialist to a market-oriented economic system after the fall of the Berlin Wall. During the
course of this transition East Germany experienced large increases in both its wage level and wage
dispersion. From 1990 to 2000 real wages in East Germany for men aged 20 to 60 rose by 118%,
while various inequality measures indicate an increase in wage inequality of 25 to 61%. In this paper
we analyze these changes in the first two moments. The increases in the mean and inequality of East
German wages are not surprising considering the transition East Germany underwent in moving to
a market-oriented system. We focus on the sources of wage growth and inequality change, asking
"How much of the changes in the level and dispersion of wages can be explained by the changes in
the characteristics of workers?" and "How much of the changes in the level and dispersion of wages
can be explained by the changes in returns to the characteristics of workers?". It is natural to also ask
how much closer the transition brings East Germany to West Germany (the pre-unification Federal
Republic of Germany or FRG). We compare our 1990-2000 results for East Germany to West
German wage earners during the same period in order to investigate whether convergences took
place in terms of mean wages (level) and wage dispersion (inequality).
2. East Germany: Background and Transition
The economic system of Eastern Germany has been of interest both during the command era
and the 1990's transition era, in part due to the unique setting of the two Germanies. Prior to the
division of Germany after World War II, the two regions had similar endowments of human capital,
similar culture, institutions and background, and similar economic characteristics such as income
levels, trade patterns and the like. However, there were differences. The area of the GDR suffered
greater loses during World War II, was ultimately a “smaller” economy facing post war development
integrated with the Soviet Bloc rather than Western trade and aid.
A critical issue distinguishing the nature of transition in different settings has been the role
of the set of initial conditions, or distortions of resource allocation left over from the command era.
Unlike most of the command economies, economic growth in the GDR was “intensive” although
familiar distortions (heavy industry emphasis, for example) could be observed. The performance
of the GDR was generally held to be among the best of the former command economies, though
arguably the standard of living in the GDR at the beginning of unification was well below that in the
The process of transition in the former GDR was quite different from that in other transition
economies, a fact which helps to explain observed outcomes during the 1990s. In a sense, the
institutions and policies of the West were implanted quickly and aggressively into the former GDR.
West German laws, financial institutions, trading arrangements and labor institutions were
transferred directly to the East. Moreover, unlike other transition economies in which sources of
capital accumulation became a major problem during transition, capital flows from West to East
were a major stimulant to the transition process in the new united Germany.
Since the beginning of the transition era, the performance of the unified German economy
has been mixed, perhaps in part a result of placing Western institutions on outdated Soviet type
structures. In this setting, it is not surprising that changes in resource allocation, for example labor
allocation, might be different in the unified German economy than in other transition economies.
An important approach to understanding and assessing the results of transition is an
examination of various measures of convergence. Since a major objective of transition is to achieve
market outcomes through newly established market mechanisms, it would seem natural to observe
outcomes such as rates of economic growth, structural changes, and changing trade patterns, asking
to what degree such indicators have, in a new setting, converged towards market expectations. In this
paper, we examine one important outcome, namely wage growth and structure, asking to what degree
observed outcomes in East Germany have converged towards West German (market) patterns during
the process of transition.
3. Wages in Transition Settings
During the command era, state enterprises dominated, wages were set by the state (with
significant wage “leveling” in a socialist setting), and full employment was generally assured through
overstaffing. As transition emerged, private enterprises replaced state enterprises, market institutions
appeared (including labor unions), and the allocation of labor and related wage structures changed.
Although it is difficult to generalize about outcomes in the many transition economies, typically
there has been a shift of employment from the public to the private sector, wage variation has
increased, while returns to education have increased in some cases, decreased in others. In most
cases, unemployment has increased and the labor force has shrunk.
There is a small but substantial literature that has looked at wage growth and inequality in
transition economies, in particular the East German economy. Hunt (2001) examines the
determinants of wage growth from 1990-1996, emphasizing the role of job changes. She finds that
low paid workers gained during the onset of the transition, while higher educated workers gained
later on, perhaps understandable in the German case where the Western model was put in place very
quickly. Franz and Steiner (2000) and Burda and Hunt (2001) address changes in the distribution of
hourly wages from 1990-1997, finding that inequality increases. Some papers (e.g., Abraham and
Houseman ,1995, Hunt, 2002, and Krueger and Pischke, 1995) discuss the effects of the transition
in terms of wage inequality and the gender wage gap. Biewen (2000) extensively analyzes income
inequality changes (based on net monthly household income), finding increased inequality in East
Germany after unification. Gang and Yun (2003) analyze the changes in wage dispersion in East
Germany. Generally, all of these papers find a widening dispersion of household income and wages.
The literature has, for the most part, either addressed wage growth (important in the transition
setting given very different wage setting processes in the command systems) or wage inequality.
However, to develop a comprehensive picture of changes in the East Germany labor market since
the fall of the Berlin Wall, we study both of these moments of the wage distribution. We employ the
standard Oaxaca (1973) wage decomposition method and a newly developed Oaxaca-type inequality
decomposition method (Yun, 2006), respectively, for analyzing the changes in mean wages and the
changes in wage inequality since the fall of Berlin Wall. The standard Oaxaca decomposition
explains wage differentials in terms of differences in individual characteristics (characteristics effect)
and differences in the coefficients of the earnings equations (coefficients effect). Yun (2006)
develops an inequality decomposition, an equivalent to Oaxaca decomposition for wage differentials
by synthesizing the methods of Fields (2003) and Juhn, Murphy and Pierce (1993) and overcoming
each own limitations. This allows us to explain changes in wage inequality in terms of changes in
characteristics and changes in returns to characteristics at various levels of aggregation, in addition
to changes in the distribution of residuals, also based on earnings equation estimates.
There is no a priori relationship between wage growth and changes in wage inequality.
However, the fact that we use the same earnings equations estimates in both our decomposition of
changes in mean wages and changes in wage dispersion (inequality) is of some interest. We consider
whether, and to what degree, the same variables in the earnings equation contribute to changes in the