Compensating Wage Differentials and its assumption

Compensating Wage Differentials:

The impact of differences in the job amenities on the determination of wage and employment Adam Smith in 1776 said the whole of the advantages and disadvantages of different employment of labour and stock should in the same neighbourhood be either perfectly equal or continually tending to equality. If in the similar neighbourhood there was any employment either evidently more or less advantageous than the rest, so many would crowd into it in the one case and so several would desert it in the other that its advantages would soon return to the level of other employments. This at slightest would be the case in a society where things were left to follow their rational course where there was perfect liberty and where every man was perfectly free both to choose what occupation he thought proper as well as to change it as often as he thought proper.

• Firms that have unlikeable working conditions must offer some offsetting advantage (such as higher wage) in order to attract workers firms that offer pleasant working conditions can get away with paying lower wage rates (in effect making workers buy the enjoyable environment).

• Workers differ in their likings for job characteristics and firms differ in the working conditions they offer. The theory of recompensing wage differentials essentially tells a story of how workers and firms “match the mate” in the labor market.


A) Two Types of Jobs:

Job with entirely safe environment – probability of being injured is zero.
Job with intrinsically risky environment – probability of being injured is one.

B) Workers have absolute information about the risk level associated with every job – the workers know whether they are employed in safe jobs or risky jobs

⇒ This assumption is very important because some risks may not be detectable for many years.

C) Model:

Utility = f (w, R)

Where w is wage as well as R is risk of injury on the job respectively.

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To convince the worker to move to the riskier job and hold her utility constant is by increasing her wage.

Reservation Price: The amount of cash it would take to bribe her into accepting the risky job (P to Q).

Δw = w$ − w 1 0: How much would it acquire to do something that you would rather not do?

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