Question

Explain with the aid of a diagram how a compensating wage differential can emerge in a competitive labour market. Assume two occupations they are identical, except that one has some undesirable characteristic. Assume that workers have heterogeneous preferences vis-a-vis the undesirable job characteristic.

Answer 1

Wage Differentials - Meaning

The wage paid to workers varies greatly. These wage differentials are mostly the result of differences in worker ability and the workers' effort in performing the job, but may also result if the job is unionized, since the goal of labor unions is to increase compensation over and above what would otherwise be provided based on free market conditions. There are also wage differentials across occupations, because of differences in the demand and supply of laborers for particular jobs or occupations. These differences arise primarily because of differences in the amount of education or training required and in the desirability of the job itself.

Compensating Wage Differentials

All jobs are not the same. Adam Smith in 1776 argued that compensating wage differentials arise to compensate workers for the nonwage characteristics of jobs. It is not the wage that is equated across jobs in a competitive market, but the “whole of the advantages and disadvantages” of the job. Compensating wage differentials provide the key to the valuation of the non-pecuniary aspects of employment.

Workers differ in their preferences for job characteristics and firms differ in the working conditions that they offer. The theory of compensating differentials tells a story of how workers and firms “match and mate” in the labour market.

The Market for Risky Jobs

Simple model : Assume only two types of jobs in the labour market (safe jobs versus risky jobs) - Safe jobs have probability of zero that worker gets injured. Risky jobs have probability of 1! Workers know this.

Workers care about whether their jobs are safe or risky.

A worker’s utility function: Utility = f (w, risk of injury)

Indifference curves reveal the trade-offs that a worker prefers between wages and degree of risk (risk assumed to be a ‘bad’): To provide the same utility, risky jobs must pay higher wages than safe jobs.

Indifference Curves Relating the Wage and the Probability of Injury on Job

The worker earns a wage of w0 dollars and gets U0 utils if she chooses the safe job. She would prefer the safe job if the risky job paid a wage of w'1 dollars, but would prefer the risky job if that job paid a wage of w2 dollars. The worker is indifferent between the two jobs if the risky job pays w1. The worker’s reservation price is then given by

Δ w^ = w^1 - w0

Determining the Market Compensating Differential

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 market compensation differential equates supply and demand, and gives the bribe required to attract the last worker hired by risky firms.