Chapter 4 Labour-1

CHAPTER FOUR
WAGE DETERMINATION AND

COMPENSATING WAGE DIFFERENTIALS
1. Wage Determination and Resource Allocation
• Introduction
• Why determining wag is very necessary?
• More than 60% of national GDP came from workers wage.
• Consumers purchasing power determined by their wage.
• Firms profit is determined by the level of wage that they pay.
• Governments goal of achieving higher level of development is
determine by wage.
Wage Determination
A. Under perfectly Competitive (on both Markets)
• In perfect competitive market both parties are price and wage

taker.
• Assumption
• Large number of firms competing each other to hire a specific
type of labor to fill identical jobs
• Numerous qualified people who have identical skills and
independently supply their labor services
• Neither workers nor firms exert control over the market wage
• Perfect, costless information and labor mobility.
Hiring Decision by an Individual Firm
Example
• 1. W= $20 No labourers Q (TPP)

p= $10 1 5
2 12
3 16
4 18
5 19
• How many should the firm Employ at equilibrium?

2. Suppose that the firm operates in a perfectly competitive market. The
market price of his product is $2 and LD=2. The firm estimates its
production with the following production function:
• How much should the firm pay at equilibrium?

Factors affecting equilibrium W, LSS &LDD
• Ch
• Change in SS and DD and the equlibrium

B. Wage Determination
Monopoly in the Product Market
• Assume, a firm is price maker in the output market
price taker in the labour market
C. Monopsony and wage determination
• It is a market where there is only one buyer of labour service.

• Assume Firm is : Price taker in the output market
Wage maker in the labour market
Assumptions:
• Large number of homogeneous workers act independently
• Information is perfect and mobility is costless
• Unlike the perfect competitor, monopsonist is a “wage-setter”
(can control the wage by adjusting the amount of labor it hires)
• Monopsonist sell its product in perfectly competitive market
(“price taker”) (MRP=VMP)
Example
Workers hired W TC MWC MRP

1 10 10 10 10
2 11 22 12 40
3 12 36 14 50
4 13 52 16 40
5 14 70 18 30
6 15 90 20 20
Summery cont...
Minimum Wage Theory
• Minimum wage is a wage approved by the government to protect the workers
(teenagers, females and minorities).
• It is wage floor in the labour market.
• To make it effective it must be above equilibrium wage rate.
Proponents argue the minimum wage
• Is needed to provide a “living wage”
• Stop exploitation by monopsonist firms
• Motivate employer for more technical efficiency
Opponents argue the minimum wage
• Increases unemployment, particularly among teenagers, females, and minorities.
• Reduces wages in sectors not covered by the law.
• Encourages teenagers to drop out of school.
• It is poorly targeted poverty
Effect of minimum wage under perfect competitive market
Effect on higher-wage labor markets
• If minimum wage is at or above the equilibrium wage and if LS and LD is
elastic, the law increase labour SS and decrease labour DD.
(unemployment)
Effect of minimum wage under the Monopsony Model
First, if government sets the minimum wage above W2, employment will
decline.
Second, even though employment may be equal to or greater than Q0 at
minimum-wage levels above the monopsony wage W0, unemployment could
easily be higher.
Cont.…
• If government sets the minimum wage above W 2, employment
will decline.
• For example, Laborers seek employment in this market at wage
W2, while firms hire only a workers.
• At W2, although employment is the same as at the monopsony
wageW0, the excess supply of workers– unemployment – rise
from zero to ab.
Summary of effect of minimum wage rate

• On employment
• On human capital
• On poverty
2. Wage Structure and Compensating Wage Differentials
• Wage structure is the hierarchy within a company that sets the

amount each level of employment is paid and that benefits each
level is due.
• Wage differential refers to disparities among wage paid to
employees in different occupations.
kinds of wage differentials
1. Equilibrium wage differential: wage differentials that do not
elicit movement of labor from the lower-paying to the higher.
2. Transitional wage differentials: promote worker mobility that
eventually reduces the wage disparities.
Causes and Measurements of Wage differentials
 What causes these wage differentials and how can they persist?
Why do some wage differences narrow overtime while other

remain?
Wage differentials occur because :

a) Jobs and employers are heterogeneous,
b) Workers are heterogeneous, and
c) Labour markets are imperfect.
a) Wage Differentials ; Jobs heterogeneous
i) Differing skill requirements

• The difference in pay between skilled and unskilled workers is called the skill
differential.
• Skill differentials can increase, decrease, or reverse wage differences caused
by compensating differentials.
ii) Differences based on Efficiency Wage payments
• Shrinking Model: firms will pay efficiency wages either where it is costly to
monitor the performance of employees or where the employers’ cost of poor
performance is high.
• Turnover model: firms will pay above-market wages when hiring and training costs
are high.
iii. Jobs have different non-wage attributes
iv) Other Job or Employer Heterogeneities
Union status
Discrimination
Firm size
b). Wage Differentials: Heterogeneous Workers
People (workers) have greatly differing stocks of human capital as well as
differing preferences for nonwage aspects of job.
i) Differing Human capital (Noncompeting Groups)
ii) Differing Individual Preferences (Differences in time preferences, differences
in tastes for nonwage aspects of jobs)
c). Wage Differentials: Labour Market Imperfections
• Wage differences also occur because of labour market

imperfections.
(i) Imperfect information
(ii) Costly migration- Institutional Immobility
Sociological immobility
-Geographic immobility’s
Compensating Differentials
• Compensating wage differentials; consist of extra pay that an
employer must provide a worker for some undesirable job
characteristic that does not exist in alternative employment.
• It is equilibrium wage differential.
Sources of compensating differentials
• Risk of job injury or death Fringe benefits
• Extent of control over the work place Job status
• Prospect of wage advancement Job location
• Job security: Regularity of Earnings
Example
U=-X
X=1 if the work is risky and = 0 otherwise
W = 36 for safe work
• Find wage for risky job.
• Find compensating wage differential.
3. The Market for Risky Jobs
The Supply of Labor to Risky Jobs (function of utility)
• Different workers have different attitudes toward risk.
• The supply curve tells us how many workers are willing to offer their services to
the risky job as a function of the wage differential between the risky job and the
safe job.
• The greater the worker’s dislike for risk, the greater the bribe required for
switching from the safe job to the risky job, and the greater the reservation price.
• As the wage differential between the risky job and the safe job keeps increasing,
more and more workers are bribed into the risky occupation, and the number of
workers who choose to work in risky jobs keeps rising.
• The supply curve to the risky job, therefore, is upward sloping.
The Demand for Labor by Risky Firms (function of profit)
• Profits depend on whether the firm offers a safe or a risky environment.
Both revenues and costs are affected by the firm’s decision.
The DD curve tells us how many employers are willing to hire labour
services to the risky job as a function of the wage differential between
the risky job and the safe job.
• If the wage gap between risky and safe firms is very large, no firm
would choose to become a risky firm and the demand for risky workers
is zero.
• If the wage differential between the risky job and the safe job keeps
falling, the number of workers demanded by risky firms rises.
• The labor demand curve for risky jobs, therefore, is downward
sloping.
Equilibrium
Hedonic Wage Theory
• The term hedonic derives from the philosophical concept of hedonism, which
hypothesizes that people pursue utility (pleasure), say, wage income, and avoid
disutility (pain).
• The worker’s Indifference Map
Employer’s Isoprofit Curve
• Employers can act to reduce the probability of job injury (increase the
safety of the workplace).
• This action will increase cost of the employer, thus, the employer faces a
tradeoff between the wages offered and the degree of job safety provided to
workers.
• To maintain any given level of profits, the firm can either
(1) pay lower wages and provide a higher degree of job safety or
(2) pay higher wages and take fewer actions to reduce the risk of job related
accidents.
Matching Workers with Jobs
• The optimal allocation of wage rate and job safety can be found by
combining workers indifference curve and firms’ isoprofit curves.
3. Labor Market Discriminations
• Discrimination occurs when labor market participants take into

account factors as race, gender and ethnicity etc.
• For instance:-
 Employers: might care about the gender of their workers they hire;
(Employer discrimination)
 Workers: might care about the race of their coworkers (Employee
discrimination); and
 Customers: might care about the race and gender of the seller
(Customer discrimination)
The Discrimination Coefficient
1. Employers (white)
Suppose there are two types of workers in the labor market: white workers
and black workers.
• A competitive employer faces constant prices for these inputs; wW is the
wage rate for a white worker and wB is the wage rate for a black worker.
• If the employer is prejudiced against blacks, the employer gets disutility
from hiring black workers.
• In other words, even though it costs only wB dollars to hire a black
worker, the employer will act as if it costs wB(1 + d) dollars, where d is
a positive number and is called the discrimination coefficient.
2. Employer (black)
Some employers might prefer to hire blacks. This type of behavior, called nepotism,
implies that an employer’s utility-adjusted cost of hiring a favored worker equals
wB(1 − n) dollars, where the “nepotism coefficient” n is a positive number.
3. Worker (white)
White workers, for instance, might dislike working alongside black workers. If a
prejudiced white worker’s wage equals wW, she will act as if her wage equals
wW(1 − d) when she has to work alongside a black worker (where d is a positive
number).
4. Customer (white)
white customers might dislike purchasing goods and services from black sellers.
The white customer would act as if the price of the good is not p dollars, but instead
equals p(1 + d).
Policy Application: Safety and Health Regulations
• The legislation created the Occupational Safety and Health

Administration (OSHA), whose job is to protect the health and safety
of the workers in the labor force.
These regulatory activities raise a number of important questions.
• Are workers better off as a result of these regulations?
• How do the safety standards alter the nature of the labor market
equilibrium that generates compensating wage differentials?
• Do these government mandates actually reduce the probability of injury
on the job?
Impact of OSHA Regulation on Wages, Utility, and Profits
−
* U
U
Wa ge
−
π
Hedonic
Wa ge
π * Function
P
w *
− Q
w
−
ρ ρ * Probability of Injur y
• Prior to the regulation, the worker chose the employment package at point P.
• The government sets a ceiling of ¯ρ on the probability of injury, shifting the worker and the firm to point
Q. The worker gets a lower wage (from w* to w¯ ), has less utility (from U* to U¯) , and the firm earns
lower profits (from π* to π¯ ).
Impact of Regulations When Workers Are Unaware of the Risks
Wa ge U 0
− *
U U
Hedonic
w * Wa ge
Function
−
ρ 0 ρ ρ * Probability of Injur y
• Workers earn a wage of w* and incorrectly believe that their probability of injury is ρ0. The
probability is actually ρ*. The government can mandate that firms do not offer a probability
of injury higher than ¯ ρ , increasing the worker’s actual utility from U* to
U ¯.

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CHAPTER FOUR

WAGE DETERMINATION AND

• In perfect competitive market both parties are price and wage

• 1. W= $20 No labourers Q (TPP)

• How many should the firm Employ at equilibrium?

• How much should the firm pay at equilibrium?

• Change in SS and DD and the equlibrium

• It is a market where there is only one buyer of labour service.

Workers hired W TC MWC MRP

Summary of effect of minimum wage rate

• Wage structure is the hierarchy within a company that sets the

Why do some wage differences narrow overtime while other

Wage differentials occur because :

i) Differing skill requirements

• Wage differences also occur because of labour market

• Discrimination occurs when labor market participants take into

• The legislation created the Occupational Safety and Health

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