Question

Define and discuss compensating wage differentials and the hedonic wage theory (HWT). Show how HWT applies to employee benefits. Discuss employee considerations and preferences (with the help of indifference curves) and employer considerations and preferences (with the help of isoprofit curves). Illustrate the join determination of wages and benefits under HWT.

Answer 1

Wage Differentials : Different wages are given to different workers to adjust for the differences in the jobs or productivity of the worker. Some reasons behind the difference is the risk associated with the job, education level , location etc.

Hedonic Wage Theory (HWT) :  This theory helps to understand the theory of compensating wage differentials for negative work features ( where in the risk of injury is high) and draw conclusions with respect to the government safety regulations.

Compensating wage differentials help in the allocative function in two ways:

1. It acts as an incentive to attract workers to take up less desirable work.

2. It also acts as an incentive to employers to diminish the undesirable notion of the job.

How does HWT apply to employee benefits:

Employee benefits refer to those incentives provided by the employer to attract employees with certain characteristics and discourage applications from others.

So, a compensating wage differential which is an additional amount of income provided to workers to motivate them to accept an undesirable job in relation to the other jobs the worker can do.

So, through the various employee benefits the workers can be attracted and motivated. Certain benefits include, insurance schemes, tax saving funds, paid vacations etc.

If the employees are fully aware of the risk associated with the job and have a choice to choose among employers the wage differential system is efficient in allocation resources.

Employee considerations and preferences:

An indifference curve is used to understand the relationship between wages ( which is in cash) and employee benefits. ( in ways other than direct cash)

At point A, the employee seems to be present-oriented and hence, prefers more cash over benefits.

Where as, at point B , the employee would be more future-oriented where more benefits are preferred over cash in hand.

Employer considerations and preferences :

Employer Preferences : They have the ability to choose the combination of cash compensation and benefits that is offered to their workers. This combination can be graphically represented through iso-profit curves.

There are three types of iso-profit curves:

A.Unitary Slope :In the graph curve II has a unitary slope. Here, the emplyer is indifferent towards paying $X as wages or $X in benefits as both cost the same and have no impact on the profits.

B. Flatter Slope : Here the trade-off between cash and benefits is not the same. As, benefits can provide the firm with tax or other advantages . ( Slope Q)

C. Steeper Slope: Providing more employee benefits than cash is more expensive than paying cash. ( Slope R)

Joint determination of wages and benefits :

1. It is assumed that the firms have a zero-profit iso-profit curve

2. Employees or workers make a trade-off between cash and benefits and employers also do the same.

For workers , their choice between the two may differ depending on their thoughts:

A. If they are future-oriented then they would prefer benefits over cash. Hence, attracted to those workers who are providing more benefits.

B. If they are more present-oriented they would want more cash in hand in the present and prefer employers who are providing more cash than benefits.

Hence, employers design their compensation package depending on the kind of employees they want to attract.

For worker A : The indifference curve meets the iso-profit curve at point S.

Sw+ Sb = Total compensation

For worker B : The indifference curve meets the iso-profit curve at point T.

Tw+ Tb = Total compensation

Here, Worker A is present -oriented as Sw>Sb . That is prefers cash over benefits.

Here, Worker B is future -oriented as Tw<Tb . That is prefers benefits. over cash.