Econ labor market policy evaluation
ECON 370 - Chapter 8 - Labour
Economics
Maggie Jones
Compensating Wage Differentials
I Our discussion thus far has mostly assumed that workers are homogenous
I One of the implications of this assumption is that wages will be the same for these workers
I In reality the wages of di↵erent members of the population di↵er substantially
I We’re going to shift focus to understand some of the ways in which wage di↵erentials can arise
Compensating Wage Differentials
I Workers may be equally productive but face di↵erent working environments for which they receive di↵erent compensation
I Adam Smith outlined 5 principals that result in di↵erential compensation I agreeableness or disagreeableness of employments themselves I easiness and cheapness or di�culty and expense of learning
them I constancy or inconstancy of employment in them I small or great trust which must be reposed in those who
exercise them I probability or improbability of success in them
The Firm
Single Firm’s Isoprofit Schedule
I We will begin by focussing on wage di↵erentials that arise due to compensation for risk of injury or illness
I Trace out firm’s isoprofit schedule to obtain all the combinations of wages and “safety” (or any job attribute) that generate a given level of profits
I Both wages and providing a safe work environment are costly and must be traded-o↵ accordingly I firm can provide more safety and maintain the same level of
profits if it can reduce wages
I Firm exhibits a diminishing marginal rate of transformation between wages and safety
w ag e
safety
Different Firms with Different
Safety Technologies
I Higher isoprofit schedules correspond to lower profits I The shape of the isoprofit schedule is determined by the
underlying safety technology I di↵erent firms can have di↵erent abilities to provide safety at
a given cost
w ag e
safety
Different Firms with Different
Safety Technologies
I The outer limits of the two isoprofit schedules are known as the market envelope curve
I They display the maximum compensating wages that will be o↵ered in the market for various levels of safety
I Note that in a competitive equilibrium, firms earn 0 profits so that I1 = I2 = 0
The Worker
Single Individual’s Preferences
I Define an individual’s preferences over wages and safety I These preferences can be represented by an indi↵erence curve I ICs exhibit a diminishing marginal rate of of substitution
between wages and safety
I When safety is “scarce” the individual will give up a large amount of wages for an incremental change in safety
I When safety is “plentiful” the individual is less inclined to give up wages
w ag e
safety
Differences in Risk Preferences
I Individuals may di↵er across their “riskiness” I e.g., risky individual does not need to be paid a much higher
wage to accept a lower level of safety I less risky individual needs to be paid a higher wage in order to
accept a lower level of safety
w ag e
safety
Equilibrium with Single Firm, Single
Individual
Equilibrium with Single Firm, Single
Individual
w ag e
safety
Equilibrium with Many Firms and
Individuals w ag e
safety
Equilibrium with Many Firms and
Individuals
I Risk averse individuals sort themselves into safer firms/industries/occupations
I Risky individuals sort into less safe firms/industries/occupations that pay high wages
I Set of tangencies between isoprofit and indi↵erence schedules outline the wage-safety locus
I slope of the wage-safety locus gives the change in the wage premium that the market yields for di↵erences in the risk of
the job I given that compensating wages are required for reductions in
safety, the only restriction on the slope of the wage-safety
locus is that it is negative
Effects of Safety Regulations
Effects of Safety Regulations
w ag e
safety
Effects of Safety Regulations
w ag e
safety
Effects of Safety Regulations
w ag e
safety
Single Firm’s Isoprofit Schedule
I Referring to the previous graph, we see that the firm’s isoprofit schedules exhibit a diminishing marginal rate of transformation
I At s = 0 the firm provides no safety. It can therefore increase safety relatively cheaply.
I Once safety increases substantially, it becomes more costly for the firm to provide increased levels of safety
Different Firms with Different
Safety Technologies
I Firm 1: safety is costly to implement (e.g. dangerous industries like mining or logging)
I Firm 2: safety is cheap to implement (e.g. o�ce job) I Outer edge of isoprofit schedules represents the market
envelope curve (a.k.a. the employer’s o↵er curve)
Equilibrium with Single Firm, Single
Individual
I In the previous graph we assume perfect competition I Firm will operate on IP schedule such that profits are equal to
0 given the safety technology that the firm faces
I Consumer will try to reach maximum utility (indi↵erence curve) given that the firm is restricted to making 0 profits
Equilibrium with Many Firms, Many
Individuals
I We imagine 3 firms: I A - least safe (costly to increase safety) I B - middle ground I C - most safe (cheap to increase safety)
I And 3 workers: I i - riskiest (don’t have to pay much higher wages to accept less
safety) I ii - middle ground I iii - risk averse (have to compensate them a lot for them to be
willing to accept lower safety)
I Equilibrium: risky workers will sort into less safe firms and receive higher wages and risk averse workers will sort into more safe firms and accept lower wages
Effects of Safety Regulations
I The previous graph represents a situation where safety regulations don’t improve the well-being of the individual
I We assume the firm operates in perfect competition and let sR represent the minimum level of safety mandated by the government
Effects of Safety Regulations
I The previous graph represents a situation where utility doesn’t decline in response to an increase in safety
I We assume the firm is not operating in perfect competition, so that profits are greater than 0
I If the firm makes profits, then to pay for an increase in safety, the firm can dip in to profits
I This is likely unrealistic in reality