4.8 – Labour Supply

A number of physicists have changed careers to become researchers in finance or financial economics. Research in finance pays substantially better than research in physics, and yet requires many of the same mathematical skills like stochastic calculus. Physicists who see their former colleagues driving Porsches and buying summerhouses are understandably annoyed that research in finance—which is intellectually no more difficult or challenging than physics—pays so much better. Indeed, some physicists are saying that other fields—such as finance, economics, and law—“shouldn’t” pay more than physics.

The difference in income between physics’ researchers and finance researchers is an example of a compensating differential. A compensating differential is income or costs that equalize different choices. There are individuals who could become either physicists or finance researchers. At equal income, too many choose physics and too few choose finance, in the sense that there is a surplus of physicists and a shortage of finance researchers. Finance salaries must exceed physics’ salaries in order to induce some of the researchers who are capable of doing either one to switch to finance, which compensates those individuals for doing the less desirable task.

Jobs that are dangerous or unpleasant must pay more than jobs requiring similar skills but without the bad attributes. Thus, oil-field workers in Alaska’s North Slope, well above the Arctic Circle, earn a premium over workers in similar jobs in Houston, Texas. The premium—or differential pay—must be such that the marginal worker is indifferent between the two choices: The extra pay compensates the worker for the adverse working conditions. This is why it is known in economics’ jargon by the phrase of a compensating differential.

The high salaries earned by professional basketball players are not compensating differentials. These salaries are not created because of a need to induce tall people to choose basketball over alternative jobs like painting ceilings, but instead are payments that reflect the rarity of the skills and abilities involved. Compensating differentials are determined by alternatives, not by direct scarcity. Professional basketball players are well paid for the same reason that Picasso’s paintings are expensive: There aren’t very many of them relative to demand.

A compensating differential is a feature of other choices as well as career choices. For example, many people would like to live in California for its weather and scenic beauty. Given the desirability of California over, for example, Lincoln, Nebraska, or Rochester, New York, there must be a compensating differential for living in Rochester; and two significant ones are air quality and housing prices. Air quality worsens as populations rise, thus tending to create a compensating differential. In addition, the increase in housing prices also tends to compensate—housing is inexpensive in Rochester, at least compared with California. There are other compensations, besides housing, for living in Rochester—cross-country skiing and proximity to mountains and lakes, for example. Generally, employment is only a temporary factor that might compensate, because employment tends to be mobile, too, and move to the location that the workers prefer, when possible. It is not possible on Alaska’s North Slope.

Housing prices also compensate for location within a city. For most people, it is more convenient—both in commuting time and for services—to be located near the central business district than in the outlying suburbs. The main compensating differentials are school quality, crime rates, and housing prices. We illustrate the ideas with a simple model of a city in the next section.

Attribution

Except where otherwise noted, the chapter is adapted from “Labor Supply” In  Introduction to Economic Analysis (LibreTexts) by Anonymous, licensed under CC BY-NC-SA 4.0./ Adaptions include: removal of section content on logarithms.