Compensating Differentials

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Dictionary of Economics

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Compensating Differentials

This is "Compensating Differentials" from our Principles of Economics: Microeconomics course.

Firms have an incentive to increase job safety, because then they can lower wages. In this video, we explore this surprising claim in much greater depth. Bear in mind that wages adjust until jobs requiring a similar level of skill have similar compensation practices. Why do riskier jobs often pay more? Why has job safety increased over the years? How does a firm’s profit motive play a role?

Teacher Resources


In this short lecture, I want to elaborate on a surprising claim made at the end of the last video. Namely that firms have an incentive to increase job safety, because then it can lower wages.


Recall that the main idea of compensating variations is that wages adjust until jobs requiring a similar level of skill have similar compensation packages. What this means is that jobs which aren't very fun, they have to have higher wages compared to similar jobs which are more fun and which therefore have to have lower wages. The same thing goes for safety. So if we were to replace fun with safety, jobs with low levels of safety have to have higher wages compared to jobs with high levels of safety which are going to have lower wages. Let's see this in another diagram.


Let's consider two fishing jobs. One in the Gulf of Mexico is low risk, the other in the frigid choppy waters of the Arctic has high risk. If the jobs require equal skill levels, then the supply of workers to the high-risk job is going to be lower, and therefore, the wage is going to be higher. In fact, the wage will adjust until the difference in wages compensates for the risk. Putting it the other way. If firms were able to make the Alaska job as safe as the Mexico job, they could pay lower wages. And what this means is that the firm has an incentive to invest in safety whenever the cost of the investment is less than the extra wages the firm has to pay to compensate the workers for risk. Moreover, the more wages that workers require to take on risk, the greater the firm's incentive to invest in safety. Now keeping this principle in mind, let's consider this along with the history of developed countries.


Job safety is much higher today in rich countries than in poor countries, and it's much higher today than in the past when rich countries were poorer. Many people think that this increase in job safety is due to government regulations and to unions, but in fact, those factors have played only a small role. The major cause of increased job safety is increasing wealth and the profit motive. As workers have become wealthier, they have demanded higher wages to take on risk, and that, in turn, has increased the incentive of firms to make workplaces safer, because firms are able to pay lower wages for safer jobs. In other words, rich workers buy more Plasma TVs and they also buy more workplace safety. The profit motive is a reason to supply workers with Plasma TVs, and it's also a reason to supply workers with safer jobs. There are, however, two qualifications. Let's take a look at those.


So the profit motive give firms an incentive to supply workers with goods, like Plasma TVs, and also to supply workplace safety. This process works, however, only when workers know about the risks. Workers won't accept lower wages to reduce risks that they don't know about. Fortunately, workers' compensation -- the government-required insurance system -- is experience rated. Firms which have more accidents pay more. So firms do have an incentive to take into account hidden risks, so long as they occur when the worker is on the job. Risks that are hidden and that don't occur on the job -- things like risks from asbestos, cancer, radiation risks, and so forth -- they will not be handled very well by the market process or by workers' compensation.


Unfortunately, no system works all that well for hidden long-run risks, but the tort system and government regulation do have a role to play in handling these hidden long-run risks. Okay, that's it for job safety and compensating variations. See you next time.


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