Compensating differential

Wage differential is a term used in labour economics to analyze the relation between the wage rate and the unpleasantness, risk, or other undesirable attributes of a particular job. A compensating differential, which is also called a compensating wage differential or an equalizing difference, is defined as the additional amount of income that a given worker must be offered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform. One can also speak of the compensating differential for an especially desirable job, or one that provides special benefits, but in this case the differential would be negative: that is, a given worker would be willing to accept a lower wage for an especially desirable job, relative to other jobs.

The idea of compensating differentials has been used to analyze issues such as the risk of future unemployment, the risk of injury, the risk of unsafe intercourse, the monetary value workers place on their own lives, and in explaining geographical wage differentials.

There is a wide literature dealing with geographical wage differentials. Following the neoclassical assumption of clearing labour markets, where there is a more attractive area to live in and if labour mobility is perfect, then more and more workers will move to this area which in turn will increase the supply of labour in this area and in turn depress wages. If the attractiveness of that area compared to other areas do not change, the wage rate will be set at such a rate that workers would be indifferent between living in areas that are more attractive but with a lower wage and living in areas which are less attractive and with a higher wage. Henceforth, a sustained equilibrium with different wage rates across different areas can happen.

The theory of compensating wage differentials provides a theoretical framework to explain why the ‘underlying’ structure of pay differs between geographical areas. Competition in labour markets ensures that the net advantages of different jobs will tend to equality. Thus, higher pay in some areas of the country is expected where the cost-of-living is higher while higher pay is also necessary to compensate for a less pleasant working environment. The rate of pay in the private sector represents (according to the hypothesis) the exact rate necessary to attract and retain staff. Thus all else equal a higher rate of pay in one area means that this area is less attractive (either has low amenity levels or higher cost-of-living). The pay offered in this area is set to counter the relative unattractiveness of the region. Some empirical studies have tried to test this assumption. Most of this research is interested in inter geographical wage disparities. The research ask the question: how can geographical wage differentials be explained?

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