COMPENSATING WAGE
DIFFERENTIALS
Abdulpatta,Fiona
Mallorca,Mary Gail
Marondo,Maria Caila
Olmilla,Claudine
Talon, Maria Christina
INTRODUCTION:
COMPENSATING WAGE
DIFFERENTIALS
 The model of competitive labor markets implies that as long as workers
or firms can freely enter and exit the marketplace, there will be a single
wage in the economy if all jobs are alike and all workers are alike.
 The labor market is not characterized by a single wage: workers differ
and jobs differ
 Adam Smith proposed the idea that job characteristics influence labor
market equilibrium
 Compensating wage differentials arise to compensate workers for
nonwage characteristics of the job
 Workers have different preferences and firms have different working
conditions
Workers’ & Firms’ Choice with RISKY JOB
EXAMPLE:
Employer X: NT.$100 per hour, clean, safe work conditions
Employer Y: NT.$100 per hour, dirty, noisy factory
 Most workers would undoubtedly choose employer X.
If employer Y decides not to alter working conditions, it must pay
wage above NT.$100 to be competitive in the labor market.
 The extra wage it must pay attract workers is called a compensating
wage differential because the higher wage is paid to compensate
workers for the undesirable working conditions.
 After the wage rise of firm Y, if both firms could obtain the quantity
and quality of works they wanted, the wage differential would be an
equilibrium differential, in the sense that there be no forces causing
the differential to change.
The Compensating Wage
Differential Serves Two Purposes:
1. It serves a social need by
giving people an incentive
to voluntarily do dirty,
dangerous, or unpleasant
work or a financial penalty
on employers offering
unfavorable working
conditions.
2. At an individual level, it
serves as a reward to workers
who accept unpleasant jobs
by paying them more than
comparable workers in more
pleasant jobs. Those who opt
for more pleasant conditions
have to buy them by
accepting lower pay.
The Compensating Wage Differential Theory
is Based on Three Assumptions
Utility Maximization
Workers seek to maximize
their utility, not their
income. Compensating
wage differentials will only
arise if some people do not
choose the highest-paying
job offered, preferring
instead a lower-paying but
more pleasant job.
Workers Mobility
Worker Information
Workers are aware of
the job characteristics of
potential importance to
them.
Workers have a range
of job offers from which
to choose. It is the act
of choosing safe jobs
over dangerous ones
that forces employers
offering dangerous
work to raise wages.
Determining the Market Compensating Differentials
The supply curve slopes up because as
the wage gap between the risky job and
the safe job increases, more and more
workers are willing to work in the risky
job. The demand curve slopes down
because fewer firms will offer risky
working conditions if risky firms have to
offer high wages to attract workers. The
market compensation differential
equates supply and demand and gives
the bribe required to attract the last
worker hired by risky firms.
FIGURE 4-5 Indifference Curve for Three types of
Workers
Figure 5-4 illustrates the indifference
curves for three different workers, A, B, and C
(with associated utilities U A , U B , and U C ).
The slope of each indifference curve tells us
how much the wage would have to increase if
the particular worker were to voluntarily switch
to a slightly riskier job. The slope of an
indifference
scurve,
therefore,
is
the
reservation price that the worker attaches to
moving to a slightly riskier job.
ISOPROFIT CURVE
An
isoprofit
curve
Figure 5-5
gives
all
the
risk-wage
combinations that yield the same profits. Because
it is costly to produce safety,a firm offering risk
level p* can make the workplace safer only if it
reduces wages (while keeping profits constant),
so that the isoprofit curve is upward sloping.
Higher isoprofit curves yield lower profit.
ISOPROFIT IMPORTANT PROPERTIES
1. Isoprofit curves are upward sloping because it
costs money to produce safety.
2. Wage-risk combinations that lie on a higher
isoprofit curve yield lower profits.
3. Isoprofit curves are concave.
5-3 Policy Application:
How Much Is a Life Worth?
Many studies estimate the hedonic function relating wages and the probability of injury on the
job. These studies estimate the wage differences that exist across jobs that offer different
probabilities of risk, after adjusting for other factors that might affect wage differentials such
as the skills of the worker, the location of the job, and so on.
Calculating Value of life
Suppose that firms X and Y each employs 1,000 workers. Because firm Y’s
probability of fatal injury exceeds that of X by .001 point, an additional worker
is likely to die in firm Y during any given year. Workers in firm Y willingly accept
this additional risk because each gets a compensating differential of $7,600.
Policy Application: Safety and Health Regulations
Since the enactment of the Occupational Safety and Health Act of 1970, the federal
government in the United States has played a major role in setting safety standards at the
workplace. The legislation created the Occupational Safety and Health Administration (OSHA),
whose job is to protect the health and safety of the American labor force. In the past 20 years, OSHA
has set workplace standards that mandate the maximum amount of cotton dust in the air in textile
plants, the amount of asbestos in the air in work settings, and a host of other restrictions on the job
environment. These regulatory activities raise a number of important questions. Are workers better
off as a result of these regulations? How do the safety standards alter the nature of the labor
market equilibrium that generates compensating wage differentials? And, finally, do these
government mandates actually reduce the probability of injury on the job?
Figure 5.7 Impact of OSHA Regulation on Wage, Profits and Utility
Impact of Regulations When Workers Are Unaware of
the Risks
We have seen that mandated safety standards reduce
both the utility of affected workers and the profitability of
affected firms. In view of this result, it is worth asking why
governments bother to regulate safety standards at all. One
argument used to justify the government mandates is that
workers are unaware of the true risks associated with
particular jobs. Construction workers in the 1950s and 1960s,
for instance, did not know that continued exposure to
asbestos fibers would eventually create serious health
problems. It is worth pointing out, however, that neither firms
nor government bureaucrats had that information, and,
hence, it is doubtful that the problem could have been
handled properly at the time.
Compensating Differentials and Job Amenities
●the model clearly applies to many other job characteristics, such as whether the job involves
repetitive and monotonous work, whether the job is located in an amenable physical setting
(southern California versus northern Alaska), whether the job involves strenuous physical work, and
so on.
● The key implication of the theory is easily summarized: As long as all persons in the population
agree on whether a particular job characteristic is a “good” or a “bad,” good job characteristics are
associated with low wage rates and bad job characteristics are associated with high wage rates.
●For example, white teachers in schools that have a predominantly black student population receive
a compensating differential
Why Do Compensating Differentials Often Go the “Wrong” Way/
●the “correct” direction of the wage differential typically reflects our own preferences and biases! We
are obviously reasonable people, so jobs we find disagreeable should pay more
●the estimates of the compensating wage differentials associated with particular job characteristics
are valid only if all the other factors that influence a worker’s wages are held constant.
●It turns out that the correlation between the change in a worker’s wage and the change in her
package of job amenities is much more consistent with the compensating differentials model.
Compensating Differentials and Layoffs
A key justification for the unemployment insurance (UI) system is that workers need to be
protected from the vagaries of the competitive labor market.
● In 2004, unemployed workers in the United States collected over $34 billion in unemployment
compensation.
● Adam Smith first noted two centuries ago, the “constancy or inconstancy of employment” will
generate compensating wage differentials.
FIGURE 5-9 Layoffs and
Compensating Differentials
At point P, a person maximizes
utility by working ho hours at a
wage of wo dollars. An alternative
job offers the worker a seasonal
schedule, where she gets the same
wage but works only h, hours. The
worker is worse off in the seasonal
job (her utility declines from U, to
U'utils). If the seasonal job is to
attract any workers, the job must
raise the wage to w₁ so that workers
will be indifferent between the two
jobs.
Health Insurance and the Labor Market
•
In the United States, employers provide health insurance coverage as a fringe
benefit to a large fraction of the workforce
•
A number of recent studies have applied the compensating differentials framework
to evaluate the relation between wages and the availability of employer-provided
insurance.
•
The worker’s indifference curve relating wages and health insurance would then
have the usual downward-sloping convex shape.
•
These data trace out the isoprofit curve, and thus indicate the trade-off implied by
the compensating differential model.
•
Most studies that attempt to calculate this trade-off do not find a negative
correlation, instead they usually find a positive correlation.
•
In recent years, the method of instrumental variables has been used to rid the data
of the ability.
•
Suppose we consider the relation between wages and health insurance coverage in
a sample of married women.
End………