Chapter 8 Compensating Wage Differentials
PURPOSES OF WAGES AND WAGE STRUCTURES
Wage structures are the relative prices of labour that are utilized用 to allocate labour to
its most productive and efficient use and to encourage human capital development—
education, training, mobility, job search—into areas yielding the highest return.
Wages are also the prices that compensate workers for undesirable job characteristics,
and, hence, they ensure that the supply of and demand for such characteristics are in
THEORY OF COMPENSATING WAGES
compensating wage differentials
Wages serve the purpose of compensating employees for undesirable working conditions
or for negative or costly attributes associated with a particular job.
Wages also compensate—by being lower than they would otherwise be—for desirable
working conditions such as flexible hours, stimulating tasks, and a pleasant working
environment including workplace practices that facilitate work-family balance. As
illustrated subsequently, many of these characteristics are associated with particular
occupations, industries, regions, or firms and hence form part of the rationale for wage
structures associated with these factors.
As a result, compensating wage differentials can account for some of the wage
differences across occupations. For instance, compensating wage differentials may
explain why high-risk occupations like construction pay more than low-risk occupations
like clerks. Chapter 8 Compensating Wage Differentials
Single Firm’s Isoprofit Schedule
I: the various combinations
of wages and safety that the
firm can provide and
maintain the same level of
For the firm, both wages
and a safe work
environment are costly to
provide; hence, the
negative trade-off between
the two; that is, the firm
can provide more safety
and maintain profits only if
it can pay a lower wage.
The isoprofit schedule exhibits a diminishing marginal rate of transformation between
wages and safety.
At point A, where the firm is providing little safety,
it can provide additional safety in a relatively inexpensive way.
It is in a stage of increasing returns with respect to the provision of safety.
In such circumstances, the firm can provide these inexpensive safety features without
requiring much of a wage reduction in order to maintain a constant profit level;
that is, the isoprofit schedule is relatively flat.
At point B, where the firm is providing considerable safety,
it can provide additional safety only through the introduction of more sophisticated and
costly safety procedures.
It is in a stage of diminishing returns in the provision of safety, having already exhausted
the cheapest forms of providing safety.
Profits are higher along Ihthan I 0 This is so because to the firm both wages and safety are
costly to provide. Hence, providing both lower wages and lower safety means higher
profits. Chapter 8 Compensating Wage Differentials
Different Firms with Different Safety Technologies
Different firms can have different abilities to provide safety at a given cost.
Hence different firms may have differently shaped isoprofit schedules even for the same
level of profit.
Illustration—the isoprofit schedules for two firms
Firm 1 exhibits rapidly diminishing returns to providing a safe work environment.
Additional safety can be provided only if wages drop quite rapidly to compensate for the
safety costs, if profits are to be maintained. (i.e. firms in sectors that are inherently
dangerous, such as mining or logging.)
Firm 2 may be in an inherently safer industry and hence be able to provide high levels of
safety without having to substantially lower wages to maintain profits.
Competitive equilibrium requires that excess profits of firms 1 and 2 are reduced to zero
(i.e., I = I = 0).
The outer limits of the two isoprofit schedules (bold line),
called the employers’ offer curve or market envelope curve,
show the maximum compensating wages that will be offered in the market for various
levels of safety.
Points within the envelope will not prevail in the market because they will always be
dominated by points on the envelope. Chapter 8 Compensating Wage Differentials
For example, for a given level of safety, S*, firm 2 is able to offer the wage W an2
maintain its given level of profit, I2.
Firm 1 can offer only the wage W and1continue to meet the zero profit condition.
Hence, firm 2’s offer will dominate firm 1’s offer for levels of safety, like S
Workers would always go to employers that offer the highest compensating wage for
every level of safety; hence, only points on the outer segments of the isoprofit schedules
will prevail in a competitive market.
Single Individual’s Preferences
Individuals will have preferences for wages and safety.
These preferences can be illustrated by a typical indifference or isoutility curve showing
various combinations of wages and safety that yield the same level of utility.
The curvature of the indifference curve
illustrates a diminishing marginal rate of
substitution between wages and safety.
At point A, where the individual does not have a very safe work environment,
that individual would likely be willing to give up considerable wages to get a slightly
safer work environment.
Hence the indifference curve is steep.
At point B, where the individual has a safer work environment,
the individual may not be willing to give up much in the form of wages to obtain
Hence, the indifference curve is relatively flat.
Higher indifference curves, like U , indicate higher levels of utility since the individual
h Chapter 8 Compensating Wage Differentials
has more of both wages and safety, both of which yield utility.
Different Individuals with Different Risk Preferences
Equilibrium with Single Firm, Single Individual
(a) illustrates the market equilibrium for a single firm and single individual as the point of
tangency, E ,cbetween the firm’s isoprofit schedule I , anc the individual’s indifference
curve U .c
This outcome occurs because a perfectly competitive market yields the maximum worker
utility subject to the firm’s earning zero economic profits.
The compensating wage, W , givec the level of safety, S , is thc highest the firm is able
to offer for that level of safety, given the zero profit constraint.
Higher indifference curves are not attainable for the worker because they would lie
outside of the feasible choice set as dictated by the employer’s isoprofit schedule, I ,
which gives the competitive level of profits.
Higher isoprofit schedules would imply profits that are below the competitive level.
Conversely, under competitive conditions, individuals would not have to accept
combinations of lower wages and safety that would put them on indifference curves
below U Oc .ourse, if firms could offer lower combinations of wages and, then workers
would be on lower indifference curves and firms would have higher profits. Chapter 8 Compensating Wage Differentials
Equilibrium with Many Firms and Individuals
Assuming perfect competition, individuals will sort themselves into firms of different
levels of risk (i.e., along the market envelope schedule) and receive differing
compensating wages for the different levels of risk.
The least risk-averse individual, for example, will enter a high-risk firm in order to get
the higher wage, W ,Lassociated with the low level of safety, SL.
The most risk-averse individual will enter the low-risk work environment and accept the
lower wage, W ,Hin order to have the safe work environment, S . H
The set of tangencies between the various isoprofit and indifference schedules gives the
various equilibrium combinations of wages and safety that will prevail in the market.
This is termed the wage-safety locus.
The slope of that locus of wage-safety combinations gives the change in the wage
premium that the market yields for differences in the risk of the job.
The slope of that line can change for different levels of safety.
It is determined by the interaction of workers’ preferences and the firms’ technology for
safety, and these basic underlying determinants may change with the level of safety. Chapter 8 Compensating Wage Differentials
The only restriction on the slope of the line is that it be negative, reflecting the fact that
compensating wages are required for reductions in safety, given worker aversion to risk
and the fact that safety is costly to firms.
• Holding worker characteristics constant (e.g. skill levels, age, experience,
race, gender, union status, region of the country, and so forth); the simple
theory leads to the prediction that CWDs will be associated with various job
• Positive differentials (higher wages) will accompany “bad” job
characteristics while negative differentials (lower wages) will be associated
with “good” ones.
– that is: W > W
BJC GJC Chapter 8 Compensating Wage Differentials
LO2 EFFECT OF SAFETY REGULATION
Perfectly Competitive Markets
The effect of safety regulation depends critically upon whether markets are operating
properly or not to compensate workers for occupational risk.
For a single representative firm and individual, the competitive equilibrium is given at E ,
with the wage, W , bcing paid for the l