- If we want people to work more, should we pay them more or will that cause them to work less?
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 . 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.
- Leisure—time spent not working—is a good like other goods, and the cost of working is less leisure.
- Labour is different from other goods because the wage enters the budget constraint twice—first as the price of leisure, and second as income from working.
- If goods and leisure are substitutes, so that an increase in L decreases the value of goods, then an increase in wages must decrease leisure, and labour supply increases in wages.
- With strong between goods and leisure, an increase in wages induces fewer hours worked.
- Complementarity between goods and leisure is reasonable because it takes time to consume goods.
- For most developed nations, increases in wages are associated with fewer hours worked.
- A is income or costs that equalize different choices.
- Jobs that are dangerous or unpleasant must pay more than jobs requiring similar skills but without the bad attributes.
- 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.
- City choice is also subject to compensating differentials, and significant differentials include air quality, crime rates, tax rates, and housing prices.
- A thought question: Does a bequest motive—the desire to give money to others—change the likelihood that goods and leisure are complements?
- Show that an increase in the wage increases the consumption of goods; that is, x increases when the wage increases.
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.
Income or costs that equalize different choices.
Flow of pleasure or happiness that a person enjoys.
The function that gives the quantity offered for sale as a function of price.
Term meaning “the derivative of.”
For a given good x, a good whose consumption increases the value of x.