Ch. 8: COMPENSATING WAGE DIFFERENTIALS AND LABOR MARKETS

• A compensating wage differential – an increment in wages required to attract workers into

a job with an undesirable working condition.

• Theory of Compensating differences. – Assumptions on Employee Side.

• workers maximize utility.• workers know job attributes and competing job offers.• workers are mobile.

wage

risk (or other "bad")

I1I2I3

• Employee preferences– Indifference curves to the NW represent higher levels

of utility.– A flatter indifference curve reflects a greater

willingness to accept money to put up with additional risk (less risk averse)

Assumptions on Employer Side.• Firms maximize profits.• Iso-profit curves show combinations of wage and risk that yield same

profit.• Iso-profit curves further to the SE represent higher levels of profits.• A steeper iso-profit curve indicates that it is more costly to eliminate

risk.wage

risk

IS0

IS1

IS2

OPTIMAL NEGOTIATIONS OVER WAGES AND RISK

• If the company and worker negotiate A, how could they both be made better off?

• If the company and worker negotiate B, how could they both be made better off?

• At what point will all the possible gains from negotiation be eliminated?

IS0

I1

A

B

MATCHING OF WORKERS AND FIRMS.

A1, A2, B1, B2 represent worker indifference curves.

X’ and Y’ represent zero profit iso-profit curves for firms X and Y

(Recall: in competitive product markets, profits are always driven to zero since firms enter/exit whenever profits are positive/negative)

• How do workers A and B compare in terms of their attitude toward risk?

• How do firms X and Y compare in terms of their costs of eliminating risk?

• If both firms offer R’ (on zero profit line)– Can firm X renegotiate a wage/risk contract that would leave

their profits unchanged but be preferred to worker A? worker B? How would the contract differ?

– Can firm Y renegotiate a wage/risk contract that would leave their profits unchanged but be preferred to worker A? worker B? How would the contract differ?

• Which type of workers get matched to X firms? Y firms?

AN ALTERNATIVE APPROACH: LABOR SUPPLY/LABOR DEMAND

Assume: • All workers can receive W0 in NR job

where there is no risk.• Workers have varying degrees of aversion

to risk on R jobs.• Least risk averse person is indifferent

between NR and R job.• What does labor supply curve for R jobs

look like?

LD

LS

W0

W1

• What is compensating difference for risk on R job?

• In terms of risk aversion, which workers end up in R job?

• Which workers are receiving “rents” for putting up with risk on R jobs?

• Which area in above diagram represents the “rents”?

• What happens in above diagram if workers become more risk averse?

• Under what conditions would firms with R jobs find it profitable to eliminate risk?

• If firms eliminated the risk, what would happen to wages in R jobs?

• Empirical application: OSHA mandates elimination of risk on R jobs.– are workers in X jobs better or worse off? by

how much?– are firms with R jobs better or worse off?– are consumers that buy products from R

better or worse off?– Other considerations:

• worker information.• worker mobility.• competitive nature of labor market.• externalities (e.g. insurance, family members)

Value of Life and Compensating Differences• qa ( qb) =probability of fatal injury on job a, b in a given

year.

• Wa ( Wb) = earnings on job a, b in a given year.

• Assume qa<qb so that Wa<Wb.

• Compensating difference=Wb-Wa

• Value of a “statistical” life = (Wb-Wa)/(qb-qa)

• Example: If a person is faced with .001 higher risk of death per year and is paid $5000 per year extra for that risk, the value of a statistical life is 5000/.001 - $5,000,000.

Viscusi. “The Value of a Statistical Life: A Critical Review of Market Estimates Throughout the World.” Journal of Risk and Uncertainty, v. 27 issue 1, 2003, p. 5.

Value of Life and Compensating Differences

• Biases in estimates of statistical value of life– Valuation is correct only for “marginal” worker.

Estimate is too high for infra-marginal worker, and too low for workers that didn’t accept job with risk.

– ex post versus ex ante rewards for risk (compensating difference vs. law suits, insurance, etc.)

– Failure to control for other risks correlated with fatality risk

– Fatality risk measured with error

FRINGE BENEFITS AND COMPENSATING DIFFERENCES.

Annual salary

$ of fringe benefits

isoprofit curve

FRINGE BENEFITS AND COMPENSATING DIFFERENCES.

• If slope=-1, firm is indifferent between paying $1 as wages or fringes.

• If fringes are “productive”, firm may be willing to add more than $1 of fringes if employee accepts $1 cut in earnings (slope < -1)– employer tax consequences– deferred pay reduces turnover– worker selection

FRINGE BENEFITS AND COMPENSATING DIFFERENCES.

• If fringes are “counter-productive”, firm is willing to add more than $1 of wages if employee accepts $1 cut in benefits.– sick pay may encourage absenteeism.– administration of fringe benefits could be expensive

OPTIMAL ALLOCATION OF COMPENSATION BETWEEN WAGES AND FRINGES

IS0

I0

I1

Fringes

Wages

OPTIMAL ALLOCATION OF COMPENSATION BETWEEN WAGES AND FRINGES

• How do workers with indifference curves I0 and I1 compare in terms of their willingness to give up wages for fringes?

• If there were many firms in the market place, which firms would attract type 1 workers? type 0 workers?

• What if all firms were forced to offer the same fringe benefit package that was between what was optimal for type 0 and 1 workers. Which workers would be better off? worse off?

APPLICATIONS

• Nondiscrimination rules in fringe benefit provision.– Effect on workers.– “Labor market segmentation”

• Fringe benefits and tax rates.