Ch. 8: COMPENSATING WAGE DIFFERENTIALS AND LABOR MARKETS

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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.

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• 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)

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• 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.

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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?

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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)
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• 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?

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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?

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• 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?

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• 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?

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• 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)

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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
• Compensating differenceWb-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.

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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.
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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 didnt 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

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FRINGE BENEFITS AND COMPENSATING DIFFERENCES.
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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
• employer tax consequences
• deferred pay reduces turnover
• worker selection

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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

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OPTIMAL ALLOCATION OF COMPENSATION BETWEEN WAGES
AND FRINGES
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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?

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APPLICATIONS

• Nondiscrimination rules in fringe benefit
  provision.
• Effect on workers.
• Labor market segmentation
• Fringe benefits and tax rates.