4.3 wage differentials and discrimination

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Wage Differentials and Discrimination 4.3

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Wage differentials

To explain the wage differentials among different industries and categories of people andjob, the influence of four factors is to be taken into account. The factors are-

I. Compensating wage differentialsII. Difference in labor quality,III. Rent elements in the wage of unique individuals,IV. Presence of non-competing group in labor market.

I. Compensating wage differentials

Some of the tremendous wage differentials observed in everyday life arise because ofdifferences in the quality of jobs. Jobs differ in their attractiveness; hence wage may have

to be raised to coax people into the less attractive job. Wage differentials that serve tocompensate for the relative attractiveness, or nonmonetary difference, among jobs arecalled compensating wage differentials. Jobs that involve hard physical, tedium, low social

prestige, irregular employment, seasonal lay off, and physical risk all tend to be lessattractive.

The theory of compensating wage differentials provides one explanation of wage differencesacross individuals and across occupations. This theory suggests that wage differentialsexist, in part, to compensate workers for non-pecuniary characteristics of alternative typesof employment. The theory of compensating wage differentials was first expressed in detail

in 1776 by Adam Smith in the Wealth of Nations, (Book I: Chapter X).

Let's consider an example to illustrate this concept. Suppose that two occupations (X and Y)are initially perceived as being equivalent in all attributes (e.g., educational requirements,

job stress, working conditions, and other characteristics). In this case, it would be expectedthat labor supply adjustments would equate wages between these two occupations (asillustrated below).

Suppose, though, that it is discovered that workers in occupation Y face a greater risk of

suffering a fatal on-the-job injury than workers in occupation X (a perfectly safeoccupation). This will induce some workers to migrate from occupation Y to occupation X.Migration continues until the wage difference between the two jobs is large enough to

induce workers to stay in their current occupations. The diagram below illustrates thispossibility.


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The wage differential w"-w' is the amount that a worker must be compensated to acceptthe additional risk associated with employment in the risky occupation. This compensating

wage differential can be thought of as the risk premium associated with employment inoccupation Y. The left-side diagram below illustrates the magnitude of this compensating

wage differential.

Ceteris paribus, it would be expected that a similar compensating wage differential wouldexist for differences in working conditions, job stress, educational requirements, and other

characteristics of jobs that make them either more or less desirable. It is expected thatmore pleasant jobs will offer lower wages than less pleasant jobs, holding all other jobcharacteristics constant.

Compensating wage differentials will reflect the market value of non-wage jobcharacteristics if:

1.workers attempt to select an occupation that maximizes their utility levels, nottheir income,

2.workers have perfect information about all job characteristics, and3.sufficient labor mobility exists.

II. Difference in labor quality

We have just discussed that some wage differentials serve to compensate for the differingdegree of attractiveness of different jobs. But by looking around us we can find clearly thatmany high paying jobs are more pleasant, at least not less pleasant, than low-paying work.

So we must look to factor beyond compensating differentials to explain most wagedifferentials.


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One key to wage disparities lies in the tremendous qualitative differences among people-traceable to difference in innate mental and physical abilities, education and training, andexperience.

A biologist might classify all of us as members of the species Homo sapiens, but a

personnel officer would insist that people differs enormously in their abilities to contributeto a firms profits.

Many of the differences in labor quality are determined outside the labor force, by geneticnurture or social nurture. Another important factor is human capital, a term that denotesthe stock of useful and valuable knowledge built up in the process of education and

training. Doctors, lawyers, and engineers invest many years in their formal education andon-the-job training. They spend vast sums on tuition and wage forgone. Part of the highsalaries of those professionals should be viewed as a return on their investment in human

capital a return on the education that makes able these highly trained workers to providevery special kind of labor.

III. Rent elements in the wage of unique individuals

For the lucky few, fame has lifted incomes to astronomical levels, reported annual earningsfor these stars, like some of the sports of film personalities, cross millions of dollars. These

extremely talented people have a particular skill that is highly valued in todays economy.Outside their specialization, they might earn only one tenth as much. Moreover, theirlabor supply may be completely unaffected by their wage rate, indicating that their labor

supply curve is completely inelastic or vertical for wages 20 or 80 or 120 percent of theirhigh compensation levels. Economists terms the excess of these wages above their bestavailable incomes in other occupations a pure economic rent, for they are logically thesame as the rent on land which is fixed in supply. Because the labor supply of these top

consultants or cricketers or musicians is completely inelastic, their efforts will respond littleto tax rates of 50 or 60 or 70 percent. Even when the net reward for their services is

reduced by taxes or market forces, they will continue to consult or play or sing.

IV. Presence of non-competing group in labor market

Even in the world of perfect competition, where people could move easily from oneoccupation to another, substantial wage differentials would appear. These differentialswould be necessary to reflect differences in the costs of education and training or in theunattractiveness of certain occupations or as rewards for unique talents.

But after accounting for all these reasons for wage differentials, we still find a largedisparity in wage rate. The major reason the difference is that labor markets aresegmented into non-competing groups. Instead of being a single factor of production. Laboris many different, but closely related factor of production. Doctor and mathematicians, for

example, are non-competing group because it is difficult and costly for a member of oneprofession to enter into the other. Just as there are many different kinds of machines, eachcommanding a different price, so are there many different occupations and skills that

compete only a general way. Once you we recognize the existence of many different submarkets of the labor market, w can see why wages may differ greatly among groups.

Why is the labor market divided into so many non-competing groups? The major reason isthat, for professions and skilled trades, it takes a large investment of time and money to

become proficient. Human resource managers can hardly hope to become cardiovascularsurgeons overnight. Nor are surgeons trained to frame a house or lay a neat roe of bricks.

Hence, once people specialize in a particular occupation, they become part of particularlabor sub market. They are there by subject to the supply and demand for that skill and will

find that their own labor earnings rise and fall depending upon events in that occupationand industry. With this segmentation, the wages for one occupation can diverge

substantially from wages in other areas.


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While the theory of non-competing groups highlights an important aspect of labor markets,we must nonetheless recognized that some competition must exist. Just as you decideweather to rent a modern computerized tractor of hire a ox to plough your field, so youmust paid choose between a high-paid professional and a low-paid, less skilled worker.

Similarly, if a electrician began to earn tk. 70,000 per month, one might study the trade

and quit being a teacher, salesman, or customer service executive.

Wage discrimination

Earning differentials are a universal feature of a market economy. But when a difference in

earnings arises simply because of an irrelevant personal characteristic such as race,gender or religion we call this discrimination.

Most of the world is nonwhite. But the white minority controls most of the economic power

and enjoys a disproportionately high standard of living. Within the most advances economicsociety, the United States, black citizens have long experienced a measurably lower level of

income and wealth than other groups. Many other minority groups also earn markedly lessthan do white Americans. In case of ethnic or religious minority, similar evidences are

available for many other countries.

Half of the population is female. How is it that a woman who has the same amount ofschooling as a man, the same scores, the same social background, nonetheless ends upwith a salary only two-thirds of what her brother of similar abilities gets?

Some earning differentials arise from differences in education, work experiences, and otherfactors; earnings disparities are inevitable in a market economy. But even after correctionfor such difference a gaps remain between the wages of some clearly identified groups(such as white male and those of other origins in USA) and also between male and female of

same group. Many high-paid occupations are traditionally reserved for men and theopposite are for female in most of the developed, developing and under developedsocieties.

Gender wage differences

The average weekly earnings of full-time female employees is significantly less than theaverage weekly earnings of full-time male employees. Most of this difference, however, canbe explained by gender-related differences in:

educational attainment, prior work experience, average weekly hours of work (on average, full-time male employees work

approximately 10% more hours than full-time female employees in USA), and

occupational choice.Some studies have found that these factors account for all of the gender wage gap, whileothers suggest that up to 1/4 of the wage gap cannot be explained using these variables.Even if these factors account for all of the wage gap, it is still possible that discrimination

may be the sources of the differences in education, employment, and occupational choice.

Economists say that discrimination occurs if workers with identical productivecharacteristics experience receive different wages or employment opportunities due todemographic characteristics unrelated to productivity. If there is no discrimination, workers


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discriminating firms will have higher profits than those firms that discriminate. Thus, firmsthat discriminate do so at a cost to their profit. In the long run, it would be expected thatthis form of discrimination would be eliminated as a result of competition.

Customer prejudice occurs when customers are willing to pay a higher price to buy goods

and services from members of a favored group. In such a situation, segregated workplacesare likely to appear, at least for those employees that interact with customers. Thesignificantly lower wages of black self-employed males is likely to be largely the result ofcustomer prejudice. Customer discrimination raises product costs for those customers that

discriminate and lowers the wages of the groups that are the targets of the discrimination.

Employee discrimination occurs when workers avoid employment that involves interactionwith those groups that are the target of their prejudice. In competitive markets, it would beprofitable for firms to hire only the targets if such discrimination (due to their lower wages).

However, in many occupations, there are insufficient numbers of minority or womenworkers available to fill such positions..

Firms rely on statistical discrimination when they have imperfect information about a

potential employee's productivity. If firms cannot reliably predict the level of a worker'sproductivity based upon only the worker's observed characteristics, they may take intoaccount group characteristics that are good predictors of individual productivity. When thisoccurs, workers with the same individual characteristics will receive different wage andemployment offers as a result of the groups to which they belong. This results in observed

discrimination against members of groups that have lower average levels of human capitaland lower levels of lifetime labor force participation. This type of discrimination lowers afirm's costs and is profitable for firms. It is not the result of prejudice, but instead a

reaction to the existence of imperfect information.

Noncompetitive models of discrimination

There are two closely related noncompetitive models that are used to explain discrimination(primarily gender-based discrimination)

crowding, and dual labor markets.

The crowding hypothesis is based on the assumption that too many women are "crowded"

into some occupations. Male dominated occupations offer higher wages because they areless crowded.

The dual labor market hypothesis refers to the distinction between the primary andsecondary labor markets. Primary sector employment involves high wages and stable

employment relationships. Low wages and unstable employment relationships characterizethe jobs available in the secondary sector.

Both of these models are based on the assumption that workers in alternative labormarkets are in non-competing groups. Under this assumption, relatively high wages in one

market will not cause a significant migration of workers to shift from the low-wage sector tothe high-wage sector.

4.3 wage differentials and discrimination

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