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Chapter 8 Compensating Wage Differentials. What affects occupational choice? wages non-pecuniary characteristics since jobs have both of these attributes,

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Presentation on theme: "Chapter 8 Compensating Wage Differentials. What affects occupational choice? wages non-pecuniary characteristics since jobs have both of these attributes,"— Presentation transcript:

1 Chapter 8 Compensating Wage Differentials

2 What affects occupational choice? wages non-pecuniary characteristics since jobs have both of these attributes, people face tradeoffs between them

3 Compare two jobs - - Both pay $7.50/hour Firm X is offering an office job as a file clerk Firm Y is an asphalt company who needs workers to help pave roads Which firm will attract more applicants at a wage of $7.50? What will have to happen at Firm Y to attract more workers?

4 The extra wage that is paid to attract workers into paving roads is called the compensating wage differential workers require "combat pay" for undesirable working conditions on the other hand, the pleasant atmosphere of desirable jobs must be bought by the workers through lower pay

5 Compensating Wage Differentials the price at which various qualitative job characteristics are bought and sold “BADS” result in positive differentials (higher wages) “GOODS” result in negative differentials (lower wages)

6 Holding worker characteristics constant, employees in “bad” jobs receive higher wages than those working under more pleasant conditions.

7 What are these worker characteristics? skill age sex race marital status education geographic region union status

8 We will assume: workers maximize utility workers have perfect information about their jobs workers have mobility

9 Utility Maximization if we used income maximization, the worker would take the highest paying job regardless of attributes this is likely not the case with most workers

10 Perfect Information workers are aware of the job characteristics and the wages paid this may not always be true for example, workers did not use to know the adverse effect of asbestos

11 Worker Mobility workers have a range of jobs to choose from and can look for a new job while working median job tenure in the U.S. is 3.5 years

12 When graphing worker preferences for wages vs. job characteristics, we use indifference curves we will put the wage on the y-axis we will put the risk of injury on the x-axis since risk is a “bad”, these indifference curves will have an unusual shape the indifference curves will be upward- sloping and convex

13 The indifference curves will be upward-sloping to accept more risk, an individual will require a higher wage to remain equally satisfied this is because the worker’s utility is lowered if they incur an injury

14 U1U1

15 R0R0 w0w0 R1R1 U1U1 Suppose a person is currently at point A. If the risk of the job rises to R 1, the person will only remain equally satisfied if... A

16 R0R0 w0w0 R1R1 w1w1 U1U1 …his wage increases to w 1.

17 U1U1 U2U2 U 2 represents a higher level of utility than U 1

18 U1U1 U2U2 R0R0 w2w2 w1w1 A B At risk level R 0, w 2 > w 1. Thus, A must be preferred to B.

19 The indifference curves will be convex at low risk of injury, the person is not as willing to accept a lower wage for an additional decrease in risk, relative to when risks are high

20 . R0R0 W0W0 Given that risks are low, the worker requires only a small increase in wage to accept additional risk U1U1

21 R1R1 W1W1 When risk is higher, the worker will require a larger increase in wage to accept additional risk U1U1

22 Joe Tom The steeper the curve, the more risk averse the worker. Joe is more risk averse than Tom.

23 Joe Tom R0R0 w0w0 What is it worth to these men to have risk lowered from R 0 to R 1 ? R1R1

24 Joe Tom R0R0 w0w0 w 1T R1R1 w 1J Joe is willing to accept a much lower wage than Tom to have risk reduced from R 0 to R 1

25 Isoprofit Curves are different across employers reflect the combinations of risk and wage that result in the same level of profit for the firm are upward-sloping and concave

26 00 Isoprofit Curve

27 Isoprofit curves are upward-sloping since reducing risk is costly to the firm, it will be willing to pay higher wages as jobs become more risky thus, there should be a positive relationship between risk and wage reflected in the isoprofit curve

28 00 w0w0 R0R0 w1w1 R1R1 A B A firm is equally profitable at A or B. Note that higher risk allows the firm to pay higher wages.

29 Isoprofit curves are concave this is due to diminishing marginal returns to reducing risk at first, firms will use safety measures that can be done so most easily and inexpensively the more safety measures employed by a firm, the more expensive and difficult additional measures will be

30 00 w0w0 R0R0 w1w1 R1R1 Risk can be reduced more cheaply at R 1 than R 0

31 11 w0w0 R0R0 22 Firms with steeper isoprofit curves find it more costly to reduce risks.

32 11 w0w0 R0R0 w1w1 R1R1 22 w2w2 To reduce risk from R 0 to R 1 and keep profit constant, Firm 1 would have to lower wages only to w 1 while Firm 2 would have to lower wages to w 2. Thus, Firm 1 can reduce the risk at lower relative cost.

33 The zero profit isoprofit curve is most often the only relevant isoprofit curve. Why?

34 Equilibrium occurs where the isoprofit curve is tangent to the indifference curve this means that the slope of the isoprofit curve is equal to the slope of the indifference curve the rate at which the firm is able to trade wages for risk is equal to the rate at which workers are willing to trade wages for risk

35 U0U0 00

36 U0U0 w* r* 00

37 Given isoprofit and indifference curves, we can show that: more risk averse workers will work at less risky jobs that pay lower wages firms with higher costs of reducing risks will pay higher wages

38 UAUA UBUB Indifference curves for two workers: Worker A and Worker B

39 ZZ XX Isoprofit curves for two firms: Firm X and Firm Z



42 Wages Rise With Risk workers with strong preferences for safety are willing to accept lower wages workers with strong preferences for safety will take jobs where safety can be generated at a lower cost

43 How do government programs controlling risk affect workers’ utility? The federal government set safety standards for many occupations through OSHA (Occupational Safety and Health Administration)

44 Suppose a firm is threatened with large fines by the government if they do not comply to safety standards. If the firm complies with the standards, are the workers better off? not if the workers know the risks the workers may be better off if they are unaware of the risks we can use our model to show this

45 w0w0 R0R0 U0U0 00

46 w0w0 R0R0 U0U0 00 R* Suppose that R* is the minimum acceptable amount of risk allowable by government standards

47 w0w0 R0R0 U0U0 00 R* The firm will only offer a wage of w* (any higher wage would reduce profit) w*

48 w0w0 R0R0 U0U0 00 R* To remain equally happy, the worker would need a wage of w R w* wRwR

49 w0w0 R0R0 R* What happens to worker utility at R*? U0U0 00 w*

50 w0w0 R0R0 R* w* U0U0 U* 00 Utility falls from U 0 to U*

51 Has government intervention helped?

52 No, the worker is made worse off

53 What happens when the worker does not know the true level of risk? In this case, government intervention can make the worker better off

54 Unknown Risk Suppose a worker receives a wage of w 0 and thinks that the risk level is R 0 the worker thinks that his utility level is U 0 but, if the actual risk is R a, the actual utility level is U a

55 w0w0 R0R0 U0U0 The worker thinks that he is at point G G 00

56 W0W0 R0R0 U0U0 RaRa 00 But the worker is actually at point A... AG

57 w0w0 R0R0 U0U0 RaRa UaUa …at utility level U a 00 G A

58 Government intervention can help in this case if the government sets the allowable risk level between R a and R b,workers will actually end up on a higher indifference curve. the workers may perceive that they are worse off (because their wage will be lower) when in fact they have been made better off (because the level of risk has been reduced)

59 w0w0 R0R0 U0U0 RaRa UaUa 00

60 w0w0 R0R0 U0U0 RaRa UaUa 00 RbRb

61 w0w0 R0R0 U0U0 RaRa UaUa RbRb R* Suppose the government chooses R* as the minimum amount of risk that is acceptable 00

62 w0w0 R0R0 U0U0 RaRa UaUa RbRb R* w* U1U1 00 The firm pays the worker a wage of w* and the worker ends up on indifference curve U 1

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