Compensating Differentials

Firms have an incentive to increase job safety, because then they can lower wages. In this video, we explore this surprising claim in much greater depth. Bear in mind that wages adjust until jobs requiring a similar level of skill have similar compensation practices. Why do riskier jobs often pay more? Why has job safety increased over the years? How does a firm’s profit motive play a role?

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- [Alex] In this short lecture,

I want to elaborate
on a surprising claim

made at the end of the last video.

Namely that firms have
an incentive to increase job safety,

because then it can lower wages.

Recall that the main idea
of compensating variations

is that wages adjust until jobs
requiring a similar level of skill

have similar compensation packages.

What this means is that jobs
which aren't very fun,

they have to have higher wages

compared to similar jobs
which are more fun

and which therefore
have to have lower wages.

The same thing goes for safety.

So if we were to replace
fun with safety,

jobs with low levels of safety
have to have higher wages

compared to jobs
with high levels of safety

which are going
to have lower wages.

Let's see this in another diagram.

Let's consider two fishing jobs.

One in the Gulf of Mexico
is low risk,

the other in the frigid
choppy waters of the Arctic

has high risk.

If the jobs require
equal skill levels,

then the supply of workers
to the high-risk job

is going to be lower,

and therefore, the wage
is going to be higher.

In fact, the wage will adjust
until the difference in wages

compensates for the risk.

Putting it the other way.

If firms were able
to make the Alaska job

as safe as the Mexico job,

they could pay lower wages.

And what this means
is that the firm has an incentive

to invest in safety
whenever the cost of the investment

is less than the extra wages
the firm has to pay

to compensate the workers for risk.

Moreover, the more wages

that workers require
to take on risk,

the greater the firm's incentive
to invest in safety.

Now keeping this principle in mind,

let's consider this along with
the history of developed countries.

Job safety is much higher today
in rich countries

than in poor countries,

and it's much higher today
than in the past

when rich countries were poorer.

Many people think
that this increase in job safety

is due to government regulations
and to unions,

but in fact, those factors
have played only a small role.

The major cause
of increased job safety

is increasing wealth
and the profit motive.

As workers have become wealthier,

they have demanded
higher wages to take on risk,

and that, in turn, has increased
the incentive of firms

to make workplaces safer,

because firms are able to pay
lower wages for safer jobs.

In other words, rich workers
buy more Plasma TVs

and they also buy
more workplace safety.

The profit motive is a reason
to supply workers with Plasma TVs,

and it's also a reason
to supply workers with safer jobs.

There are, however,
two qualifications.

Let's take a look at those.

So the profit motive
give firms an incentive

to supply workers with goods,
like Plasma TVs,

and also to supply
workplace safety.

This process works, however,

only when workers
know about the risks.

Workers won't accept
lower wages to reduce risks

that they don't know about.

Fortunately, workers' compensation --

the government-required
insurance system --

is experience rated.

Firms which have
more accidents pay more.

So firms do have an incentive
to take into account hidden risks,

so long as they occur
when the worker is on the job.

Risks that are hidden
and that don't occur on the job --

things like risks
from asbestos, cancer,

radiation risks, and so forth --

they will not be handled very well
by the market process

or by workers' compensation.

Unfortunately,
no system works all that well

for hidden long-run risks,

but the tort system
and government regulation

do have a role to play in handling
these hidden long-run risks.

Okay, that's it for job safety
and compensating variations.

See you next time.

- [Narrator] If you want
to test yourself,

click "Practice questions,"

or if you're ready to move on,
just click "Next video."

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