Ch 8 COMPENSATING WAGE DIFFERENTIALS AND LABOR MARKETS
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.
• 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)
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.
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?
MATCHING OF WORKERS AND FIRMS. A 1, A 2, B 1, B 2 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)
• 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?
AN ALTERNATIVE APPROACH: LABOR SUPPLY/LABOR DEMAND Assume: • All workers can receive W 0 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?
• 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”?
• 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?
• 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)
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<qb so that Wa<Wb. • Compensating difference=Wb-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.
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.
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 didn’t 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
FRINGE BENEFITS AND COMPENSATING DIFFERENCES.
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 < -1) – employer tax consequences – deferred pay reduces turnover – worker selection
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
OPTIMAL ALLOCATION OF COMPENSATION BETWEEN WAGES AND FRINGES
OPTIMAL ALLOCATION OF COMPENSATION BETWEEN WAGES AND FRINGES • How do workers with indifference curves I 0 and I 1 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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