Chapter 8

Compensating Wage Differentials

What affects occupational choice?

wages non-pecuniary characteristics since jobs have both of these attributes, people face tradeoffs between them

Compare two jobs - - Both pay $7.50/hour

Firm X is offering an office job as a file clerk Firm Y is an asphalt company who needs workers to help pave roads Which firm will attract more applicants at a wage of $7.50? What will have to happen at Firm Y to attract more workers?

The extra wage that is paid to attract workers into paving roads is called the compensating wage differential
workers require "combat pay" for undesirable working conditions on the other hand, the pleasant atmosphere of desirable jobs must be bought by the workers through lower pay

Compensating Wage Differentials

the price at which various qualitative job characteristics are bought and sold BADS result in positive differentials (higher wages) GOODS result in negative differentials (lower wages)

Holding worker characteristics constant, employees in bad jobs receive higher wages than those working under more pleasant conditions.

What are these worker characteristics?

skill age sex race marital status education geographic region union status

We will assume:
workers maximize utility workers have perfect information about their jobs workers have mobility

Utility Maximization
if we used income maximization, the worker would take the highest paying job regardless of attributes this is likely not the case with most workers

Perfect Information
workers are aware of the job characteristics and the wages paid this may not always be true for example, workers did not use to know the adverse effect of asbestos

Worker Mobility
workers have a range of jobs to choose from and can look for a new job while working median job tenure in the U.S. is 3.5 years

When graphing worker preferences for wages vs. job characteristics, we use indifference curves
we will put the wage on the y-axis we will put the risk of injury on the x-axis since risk is a bad, these indifference curves will have an unusual shape the indifference curves will be upwardsloping and convex

The indifference curves will be upward-sloping

to accept more risk, an individual will require a higher wage to remain equally satisfied this is because the workers utility is lowered if they incur an injury

Wage

U1

Risk

Suppose a person is currently at point A. If the risk of the job rises to R1, the person will only remain equally satisfied if...

Wage

U1

w0

R0

R1

Risk

Wage

his wage increases to w1.

U1

w1

w0

R0

R1

Risk

U2 represents a higher level of utility than U1

Wage

U2 U1

Risk

At risk level R0, w2 > w1. Thus, A must be preferred to B.

Wage

U2 U1

w2

w1

B R0
Risk

The indifference curves will be convex

at low risk of injury, the person is not as willing to accept a lower wage for an additional decrease in risk, relative to when risks are high

Wage

Given that risks are low, the worker requires.only a small increase in wage to accept additional risk

U1

W0

R0

Risk

W1

Wage

U1

When risk is higher, the worker will require a larger increase in wage to accept additional risk

R1

Risk

Wage

Joe

Tom

The steeper the curve, the more risk averse the worker. Joe is more risk averse than Tom.
Risk

Wage

Joe

Tom

w0

What is it worth to these men to have risk lowered from R0 to R1?

R1

R0

Risk

Wage

Joe

Tom

w0 w1T w1J R1

Joe is willing to accept a much lower wage than Tom to have risk reduced from R0 to R1
R0
Risk

Isoprofit Curves
are different across employers reflect the combinations of risk and wage that result in the same level of profit for the firm are upward-sloping and concave

Wage

Isoprofit Curve

Risk

Isoprofit curves are upward-sloping

since reducing risk is costly to the firm, it will be willing to pay higher wages as jobs become more risky thus, there should be a positive relationship between risk and wage reflected in the isoprofit curve

Wage

A firm is equally profitable at A or B. Note that higher risk allows the firm to pay higher wages.
0 B

w1

w0

R0

R1

Risk

Isoprofit curves are concave

this is due to diminishing marginal returns to reducing risk at first, firms will use safety measures that can be done so most easily and inexpensively the more safety measures employed by a firm, the more expensive and difficult additional measures will be

Wage

Risk can be reduced more cheaply at R1 than R0

0

w1 w0

R0

R1

Risk

Firms with steeper isoprofit curves find it more costly to reduce risks.
2

w0

Wage

R0

Risk

To reduce risk from R0 to R1 and keep profit constant, Firm 1 would have to lower wages only to w1 while Firm 2 would have to 2 lower wages to w2. Thus, Firm 1 can reduce the risk at lower relative cost.
1

w0 w1 w2

Wage

R1 R0

Risk

The zero profit isoprofit curve is most often the only relevant isoprofit curve.
Why?

Equilibrium
occurs where the isoprofit curve is tangent to the indifference curve this means that the slope of the isoprofit curve is equal to the slope of the indifference curve the rate at which the firm is able to trade wages for risk is equal to the rate at which workers are willing to trade wages for risk

Wage

U0

Risk

Wage

U0

w*

r*

Risk

Given isoprofit and indifference curves, we can show that:

more risk averse workers will work at less risky jobs that pay lower wages firms with higher costs of reducing risks will pay higher wages

Wage

UA

UB

Indifference curves for two workers: Worker A and Worker B

Risk

Wage

Isoprofit curves for two firms: Firm X and Firm Z

X

Risk

Wage

UA X

Z wA

RA

Risk

Wage

UA

UB X

wB
Z wA

RA

RB

Risk

Wages Rise With Risk

workers with strong preferences for safety are willing to accept lower wages workers with strong preferences for safety will take jobs where safety can be generated at a lower cost

How do government programs controlling risk affect workers utility?

The federal government set safety standards for many occupations through OSHA (Occupational Safety and Health Administration)

Suppose a firm is threatened with large fines by the government if they do not comply to safety standards. If the firm complies with the standards, are the workers better off?
not if the workers know the risks the workers may be better off if they are unaware of the risks we can use our model to show this

Wage

U0

0
w0

R0

Risk

Suppose that R* is the minimum acceptable amount of risk allowable by government standards

Wage

U0

0
w0

R*

R0

Risk

Wage

The firm will only offer a wage of w* (any higher wage would reduce profit)

U0

0
w0 w*

R*

R0

Risk

Wage

To remain equally happy, the worker would need a wage of wR

U0

0
w0 wR w*

R*

R0

Risk

Wage

What happens to worker utility at R*?

U0

0
w0 w*

R*

R0

Risk

Wage

Utility falls from U0 to U*

U0 U*

0
w0 w*

R*

R0

Risk

Has government intervention helped?

No, the worker is made worse off

What happens when the worker does not know the true level of risk?
In this case, government intervention can make the worker better off

Unknown Risk
Suppose a worker receives a wage of w0 and thinks that the risk level is R0 the worker thinks that his utility level is U0 but, if the actual risk is Ra, the actual utility level is Ua

Wage

The worker thinks that he is at point G

U0

0
w0 G

R0

Risk

Wage

U0

But the worker is actually at point A...

0

W0

R0

Ra

Risk

U0
Wage

Ua

at utility level Ua

0 w0 G A

R0

Ra

Risk

Government intervention can help in this case

if the government sets the allowable risk level between Ra and Rb,workers will actually end up on a higher indifference curve. the workers may perceive that they are worse off (because their wage will be lower) when in fact they have been made better off (because the level of risk has been reduced)

Wage

U0

Ua

0
w0

R0

Ra

Risk

Wage

U0

Ua

0
w0

Rb

R0

Ra

Risk

Suppose the government chooses R* as the minimum amount of risk that is acceptable

U0

Wage

Ua

0
w0

Rb

R* R0

Ra

Risk

U0
Wage

Ua

The firm pays the worker a wage of w* and the worker ends up on indifference curve U1

U1

w0 w*

Rb

R* R0

Ra

Risk