Labour Economics assignment 1
Chapter Eight Compensating Wage Differentials
© 2012 McGraw-Hill Ryerson Ltd.
Prepared by Dr. Amy Peng
Ryerson University
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Learning Objectives
Explain how labour market transactions between employers and employees are able to attach a “price” (compensating wage) to various attributes of a job.
Describe the conditions under which the market can yield an optimal amount of risk at the workplace, and the conditions under which that amount is not likely to be optimal.
Explain the conditions under which government health and safety regulations can affect the amount of safety at the workplace in a way that either increases social welfare or decreases it.
Explain that there is “no such thing as a free lunch” in that workers generally “pay” for desirable workplace characteristics by accepting a lower wage in return for such characteristics.
Explain how estimates of the compensating wage premium that is paid for workplace risks can be used to provide estimates of the value of a (statistical) life.
Chapter 8
© 2012 McGraw-Hill Ryerson Ltd.
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Theory of Compensating Wages
Factors affecting compensation for wages:
Agreeableness/disagreeableness of job
Ease/difficulty and cost of learning job
Turnover in a particular job
Degree of power and trust held
Probability or improbability of success in job
Safety risks involved in performing the job
Chapter 8
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Compensating Wages and Safety
Isoprofit Schedule (I):
Combinations of wages and safety that the firm can provide and maintain the same level of profit
IP curve exhibits a diminishing marginal rate of transformation between wages and safety
Lower curves imply higher levels of profits
Chapter 8
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Isoprofit Schedule
Chapter 8
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A
Firm is providing little safety and can provide additional safety in a relatively inexpensive manner
B
Firm is providing considerable safety and can provide additional safety only through the introduction of more sophisticated and costly procedures
Wage
Safety
Ih
Io
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Different Firms with Different Safety Technologies
Different firms have different abilities to provide safety at a given cost and, hence, there are different isoprofit curves for the same level of profit for different firms.
Chapter 8
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Different Firms with Different Safety Technologies
Chapter 8
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Wages
Safety
I1
Firm 1
I2
Firm 2
Outer edge = Employer’s offer Curve or market envelope
S*
W2
W1
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Individual’s Preferences
Illustrated by an iso-utility (indifference) curve
combinations of safety and wage that yield the same level of utility
Different risk preferences
May be willing to give up safety for a compensating risk premium
Chapter 8
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Worker Indifference Curves
Chapter 8
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W
Safety
W
Safety
Single individual
Two individuals
UO
Uh
A
B
Ub
Ua
Less risk averse
More risk averse
W0
S0
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Equilibrium with Single Firm and a Single Individual
Tangency between the iso-utility curve and the isoprofit curve
Yields the optimal wage and safety level
Chapter 8
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Market Equilibrium
Chapter 8
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W
Safety
EC
UC
IC
Wc
Sc
Single firm and single individual
Perfect competition restricts the
possible combinations to those on IC , the firm’s zeroprofit isoprofit schedule. Workers will choose jobs
that yield the highest utility, which is given by the tangency at EC .
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Equilibrium with Many Firms
Assuming perfect competition
Individuals will sort themselves into firms of different risks
receive compensating wages
Wage-safety locus
various equilibrium combinations of wages and safety
Chapter 8
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Many Firms and Many Individuals
Chapter 8
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Wages
Safety
Uc
Ua
Um
Wage-safety locus
Employer’s offer curve
Least risk-averse
Most risk averse
WL
SL
WH
SH
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Characteristics of the Wage-Safety Locus
Slope is negative
compensating wages are required for reductions in safety
The slope can change for different levels of safety
Determined by the workers’ preferences and the firms technology for safety
Chapter 8
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Effect of Safety Regulation
Perfectly Competitive Markets
Regulation requiring an increased level of safety would cause one or both parties to be worse off.
Chapter 8
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Response to Safety Standard
Chapter 8
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Wc
Sc
Uc
Ec
Wr
Sr
Ur
Er
Ic
Reduced Worker Utility
Safety
Wages
The zeroprofit constraint means that the firm can provide this only at the lower wage Wr. The worker is worse off.
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Response to Safety Standard
Chapter 8
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Wc
Sc
Uc
Ic
Reduced Employer Profits
Safety
Wage
Wr
Sr
Ir
The worker’s utility is maintained at Uc , but the firm’s profits are reduced to Ir. If profits are negative, the firm will go out of business.
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Response to Safety Standards
Chapter 8
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Wage
Safety
U
Sr
I1
I2
I3
Different Responses of different firms
The impact of the regulation will depend on the firm’s technology, and some firms (such as firm 1) will go out of business.
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Imperfect Information
If a worker misperceives the utility, then the imposed safety standards could improve workers utility without making employers worse off
Providing parties with correct information would also lead to optimal amounts of safety
Chapter 8
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Effect of Imperfect Information
Chapter 8
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Wo
So
Uo
Eo
Wage
Safety
Ua
Sp
Up
Wa
Sa
Sr
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Rationale for Regulation
Information is not perfect
Competition may not prevail
Worker does not bear all the cost of an accident
Social opinion
Worker may prefer a safer environment
Chapter 8
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Safety Regulation: The Behavioural Economics View
Four important findings:
“risk as feelings”
“hyperbolic discounting”
“theory of mental departments”
“wishful thinking bias
Chapter 8
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Empirical Evidence on Compensating Wages
Obtaining empirical evidences is difficult
Errors-in-variables problems
Omitted variable bias
Sample selection bias
Family-friendly workplace practices
Policy Implications
Chapter 8
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Summary
Wage differentials in an integrated labour market
Wage differences related to factors other than productivity aspects of jobs
A model of compensating wage differentials
Work safety and workers attitude towards work place risk
Market wage-safety locus
Empirical evidence
The impact of government regulation of work place safety
Chapter 8
© 2012 McGraw-Hill Ryerson Ltd.
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