1 Wage Differentials

We have seen that any realistic analysis of labour markets

must allow for both heterogeneities of labour and market
imperfections. Indeed, one of the major defects of the simple
marginal productivity approach is that it says very little
about differentials in wages between different types of
workers in different labour markets. To this problem we now
turn.
The most comprehensive treatment of the subject
(Reynolds and Taft [77]) deals with five types of differential.
Two of these — interpersonal and inter-firm — have already
been discussed. What follows is concerned with
occupational, inter industry and geographical wage
differentials. The fragmentation of labour markets is most
obvious along occupational lines. Mobility between
occupations tends to be more impeded, by 'market' and 'non-
market' forces, than mobility between industries and even
regions. (At least as a generalisation — movement from
floor-sweeper to labourer is clearly less difficult than
mobility of floor-sweepers from northern Scotland to
London.) Differences in pay between occupations form a
large part of the differentials between industries, and industry
differentials account for a major part of regional differentials.
These rather pragmatic considerations determine our order of
treatment.

OCCUPATIONAL DIFFERENTIALS

Adam Smith ([88] pp. 112—23) suggested five reasons for

differences in pay between occupations. Firstly, the
'agreeableness' of the job: net advantages, not merely cash
payments, must be considered. Secondly, the degree of
constancy of employment, the liability to unemployment in
different occupations. Thirdly, the 'probability of success'
differs between
jobs, being less for barristers than for solicitors, for example.
Both these factors suggest that discounted expected earnings
over a lifetime are what is involved in rational job choice,
rather than pay at any one point in time. Fourthly, 'the trust to
be reposed in the worker', or responsibility requirements :
goldsmiths in Srnith's day, workers maintaining expensive
and delicate machinery in our own, are well paid on this
account. Lastly, the 'cost of learning the trade', comprising
tuition fees and earnings forgone while undergoing training.
(In modern terms this is 'human investment' ; cf. Becker [3].)
Abstracting from the first four factors, the fifth provides
us with a simple long-run theory of occupational wage
differentials. Assume that workers bear all the costs of
investing in themselves. If natural ability is irrelevant,
training open to all, and all non-pecuniary advantages
identical, the long-run supply of every occupation will be
perfectly elastic: pay differentials between jobs will equate
the rates of return on the various amounts of human
investment required. These assumptions may be modified —
e.g. by allowing for variations in the suitability of workers
for positions of responsibility — without substantially
altering the conclusion that differences in pay depend largely
on differences in the level of education and training required
for different jobs. The demand for each occupation has no
impact, and relative shifts in demand will have no effect on
differentials.
An alternative theory of occupational wage differentials
can be developed by reversing one or two of these crucial
assumptions. Again assume that non-pecuniary factors are
identical, and that Smith's second and third elements are
inoperative, so that the risks of failure and unemployment do
not differ between occupations. Suppose, however, that
natural ability is all-important, that part of the labour force is
born as sheep and part as goats, and that their abilities cannot
be altered by education or training. Then, since the supply of
each is perfectly inelastic, their earnings will differ only
because of differences in the strength of demand for their
services. If goats are in greater demand, they will be paid
more, and earn a rent equal to their differential over the
sheep. Changes in this differential will occur only because of
changes in relative
demand. (For an exposition of both models, see Reder
It is unnecessary — and unwise— to rely solely on genetic
differences to derive a theory of occupational wage
differentials. The division of society into non-competing
groups may occur on other grounds: for example, social
prejudice (the lack of Cockney ambassadors) or inequality in
educational opportunity. Both factors may be eliminated in
the long run as occupational supply curves become much
more elastic. The consequent narrowing of differentials
suggests that the goats were only earning quasi-rents. A
process of this sort will often occur if training periods are
long and changes in demand cannot easily be foreseen: the
relatively high earnings of computer staff in the 1960s are an
example. Demand factors tend to dominate occupational
differentials in the short run, and underlying supply factors
(above all human investment) in the long run.
We know (Reynolds and Taft [77]) that there was a secular
decline in occupational wage differentials in both the U.K.
and the U.S. over the last half-century. This is true in general
between both manual and white-collar workers (Routh [85]),
and skilled and unskilled manual occupations. There is also
some evidence that differentials have moved counter-
cyclically, tending to rise in depressions and fall in booms.
(Ozanne [64] denies this tendency, but his data are drawn
from one firm only.) How far are these trends explicable in
terms of our simple models, and what alternative
explanations can be offered ?
Part of the reduction in differentials must be attributed to
the massive and general expansion in state education. This,
with increased equality of access to human investment, has
reduced the rate of return to it, partially breaking down the
barriers between non-competing groups. In the U.S. the
cessation of mass immigration of unskilled labour was an
additional factor. It has also been suggested (Keat [39]) that,
as incomes rise, the non-monetary factors in a job become
increasingly important to the worker, encouraging him to
prefer lower-paid but more enjoyable work. If occupational
supply curves are imperfectly elastic even in the long run,
shifts in relative labour demand may have affected
differentials. Modern technology is often assumed to have
stimulated the substitution of less skilled for more highly-
skilled labour, and this would tend to reduce differentials.
Reder [68] suggests that the loosening of hiring standards
in booms increases the supply of skilled labour relatively to
that of unskilled, and the reverse process operates when
aggregate demand is low. He explains the failure of
differentials to widen in some slumps by the existence of a
conventionally accepted 'social minimum' standard below
which the lowest-paid are not allowed to fall. Partial support
for his thesis comes from the tendency for the relative
severity of unemployment of lowlyskilled workers to
increase in depressions. Oi's [63] theory of labour as a semi-
fixed factor leads to similar conclusions via differential
fluctuations in labour demand.
One big problem is the evidence — clear for the U.K., less
so for the U.S. — that major reductions in occupational
differentials have been sudden, coming during and
immediately after the two world wars, and breaking periods
of long-run stability which in some cases lasted for centuries
(Phelps Brown and Hopkins [11]). But changes in education,
and in relative demand under the influence of technical
progress, have been much more gradual. This gives rise to an
identification problem, for these periods of major change
have coincided with rapid inflation (Perlman [66]) and the
growth of mass unionism among lower-skilled workers
(Turner [97]). Either or both might be held responsible for
narrowing differentials independently of broader economic
factors. Routh [85] suggests that occupational differentials
are inherently stable because of social conservatism, being
displaced only by major shocks. A compromise position is
possible: changes in the relative supply of and demand for
different occupations play only a permissive role, requiring
specific institutional forces to bring them into operation.
Reynolds and Taft [77] make a similar point in arguing that
American differentials were too high, on simple economic
criteria, at the turn of the century, and that union pressure has
produced a more optimal occupational wage structure.
INTER-INDUSTRY DIFFERENTIALS

Assume, with Reder [69], a perfect labour market with

homogeneous labour in each occupation. All workers in each
occupation are thus paid the same. Average wages can differ
between industries only because of differences in the
'skillmix' : industry A's average wage will exceed industry
B's if and only if A has a larger proportion of highly-skilled
workers. If inter-industry differentials do exist, they will
change only if there are changes in occuPational wage
differentials, or differential changes in the skill-mix. (A's
percentage wage advantage over B will widen if, for
example, its skill-mix improves while B's remains the same.)
Reder relaxes the assumption of perfect occupational
labour markets with the postulate that the short-run supply
curves of specific occupations to specific industries are
upward-sloping. To expand its labour force, A must pay each
occupation a premium over its earnings in B. Thus in the
short run changes in inter-industry differentials will be
positively correlated with relative changes in employment
between industries ; in the long run this relationship
disappears as equilibrium is restored. Evidence on this
hypothesis is conflicting, and testing raises important
analytical problems (Perlman [65]).
Other empirical evidence strengthens our doubts as to the
validity of either the long- or the short-run version of Reder's
theory. The following have been found, although not
unanimously, to be relevant to the structure and evolution of
interindustry wage differentials: trade union activity (Lewis
[51]) ; product market concentration (Weiss [99]) and the
average size of plants; profitability and the level and rate of
growth of productivity (e.g. Brown [8]). All these factors are
inconsistent with Reder's simple models. Even productivity
differentials present problems, for if labour mobility is
perfect and the law of equal price prevails, either long-run
marginal productivities are equal in all industries or
equilibrium conditions are absent.
The influence of trade union activity will be explored
below. At least part of the contribution of product market
concentration to inter-industry differentials seems to be
explained by the higher-paying firms having 'the pick of the
market', selecting the ablest members of each
(heterogeneous) occupational group (Weiss [99]). The role
of plant size and profits may be explained in the same way,
though in view of our knowledge of substantial market
imperfections even within localities this is unlikely to be the
whole answer.
It is unclear how far these factors influence the course of
inter-industry differentials over time. One would not, for
example, expect highly concentrated or well-unionised
industries to have a long-term tendency to pull away from
the others in the earnings league. The actual trend of inter-
industry differentials is still disputed, though it seems that
the ranking of industries by average wages has been
relatively stable in the long term, while the percentage
dispersion has probably narrowed (Cullen [16]). (Absolute
cash dispersion is unlikely to have narrowed; a 50p weekly
differential, huge in 1900, is probably within the margin of
statistical error today !)
The forces of inertia can easily be exaggerated, and major
short-run fluctuations ignored; in one U.K. depression
(1920— 4) money-wage reductions ranged from zero to 60
per cent. Likewise there is still little agreement generally on
the factors influencing changes in the inter-industry wage
structure. This would perhaps be no great loss, except that
wage statistics are generally collected on an industry basis
(in the U.K. to the exclusion of almost all others).

GEOGRAPHICAL DIFFERENTIALS

One reason for the plight oflow-wage areas is the

concentration of low-paying industries that they have
collected (Ministry of Labour [60]) — the industry-mix. This
in turn is partly a reflection of regional variations in the skill-
mix. Low-wage regions are weak in their endowments of
highly-trained, well-educated labour. Regional wage
differentials may thus be seen as the sum of two elements:
an excess of low-paying jobs, due to unfavourable skill- and
industry-mixes; and a tendency for relatively low earnings in
each job. The typical research procedure has been to
standardise for one or more of these explanatory variables,
and to treat the residual differential as reflecting exploitation
in the technical sense of unequal pay for equal work.
These techniques have been widely used to analyse the
North—South differential in the U.S. Fuchs [26] obtains a
very crude approximation of the effects of regional
differences in the skill-mix by assuming that the South's
stock of human capital was the same as that of the rest of the
U.S., and found that one-third of the unadjusted wage gap
between the South and the national average was thus
explained. A further third was found, by a similar procedure,
to be due to the smaller average size of Southern towns and
cities (reflecting, perhaps, greater employer monopsony
power in small labour markets). Much of the residual third
seems due to racial discrimination: not only do Blacks form
a major part of the Southern labour force, but racial
discrimination in employment is more severe in the South
than in the U.S. as a whole.
Fuchs and Perlman [27] used a similar procedure in
showing that the South's inferior industry-mix was a major
cause of the differential. They estimate that the South's
 relative wage level will rise only slowly, for the industries
which it is attracting have been precisely those with a
relatively low average wage in the U.S. as a whole. It is not
clear how this finding can be reconciled with Scully's [87]
report that the capital—labour ratio — and hence, ceteris
Paribus, labour productivity — is now above the national
average in the South. This refers only to physical capital;
Scully found that the South's deficiency in human capital was
the single biggest factor in the region's continued wage
disadvantages, with racial discrimination running it a close
second.
All researchers are agreed that the South's relative earnings
level has slowly improved since 1900, a finding which is.
repeated in fragmentary evidence for low-wage areas in the
U.K. (Knowles and Robertson [44]). It is uncertain how far
this has been due to the in-migration of capital predicted by
theory and verified by Scully's results, and how far to
institutional factors like the extension ofunionisation to the
South, and Federal minimum wage legislation. (In Britain the
emergence of industry-wide collective bargaining seems to
have been the single most important factor.) Confusion is
increased by the
dispersion of regional differentials between industries: some
Southern industries pay more than their Northern counterparts,
and some very much less (Lester [50]). This evidence,
confirmed by a rudimentary examination also for regional
differentials in Britain, serves to underline the severe limits to
our knowledge of wage differentials generally.