Study Guide 2

 

COMPENSATING WAGE DIFFERENTIALS AND LABOR MARKETS

We started with the concept of compensating wage differentials. Following the practice in traditional economics, I tried to move from 202 concepts to new concepts and tools. Note how we moved from a very 202 level with a two-graph framework to an advanced model with indifference curves and isoprofit lines.  

List of Major Concepts

1. In the context of full information and choice, worker behavior will generate compensating wage differentials for job characteristics that are unpleasant or costly.

2. Compensating differentials play a dual role in allocating labor to unpleasant jobs and in compensating those who accept unpleasant work.

3. The prediction that there will exist compensating wage differentials for unpleasant work rests on assumptions of utility maximization (not income maximization), worker information, and worker mobility.

4. Employee preferences are graphically expressed in the concavity and slope of indifference curves.  No need to worry about concavity, but you should be able to compare steep versus flat indifference curves.

5. Employers with different costs of eliminating unpleasant job characteristics can be graphically represented.  (Does a high cost of reducing risk translate into a flat or steep isoprofit?) 

6. A market equilibrium curve (or offer curve) is derived from the zero-profit isoprofit curves of the employers in the market.

7. If the market is working properly, employees who are least averse (Do they have steep or flat IC?) to an unpleasant job characteristic become employed with firms that find it most expensive to eliminate that characteristic.

8. The theory of compensating differentials can only be tested using techniques that control for other influences on job characteristics.

9. Government attempts to regulate the outcome of labor market decisions that are made in a perfectly functioning market could lead to a reduction of utility for the workers the government is intending to help.

10. Government intervention into the labor market can increase worker utility if the market is not functioning perfectly (that is, if not all costs or benefits of the decision are borne by those making them).

Empirically, labor economists explore wage differences through a hedonic model.  The though behind the model is that people behave in ways that they thought would maximize their happiness and pleasure.  Economists would use the word utility, but if you think they sound hedonistic, you understand the name of the model.

The primary method of determine the differences is through regression analysis.  We explored basic regressions with our homework.  We limited the differences to age, experience, education, and sex. Obviously, there are a myriad of potential variable.  Commonly used variables include, skill, age, sex, race, marital status, education, religion, union status, risk level, pleasant level, industry, and many more.

While we are not going to derive the regression model as in your stats classes, it is worthwhile to understand the basics.

The goal of a regression is to provide the "best" line through a set of data points.

    Any straight line can be expressed by Y = a + bX  

        Variable Y is the dependent variable

        and variable X (or a series of Xs) is the independent variable.

By using Excel or any other stats program, we can minimize the sum of the squared errors to get estimates of a and b.  (If you are not convinced of this I will be glad to show you in class.  It not only has calculus, but has partial derivates of matrices, which is definitely fun.)

    The a or alpha variable is the y-intercept

    The b or beta variable is the slope variable.  It should be interpreted as, "A one unit increase in the X variable will result in a beta unit increase in the Y variable."

In addition to the interpretation, you should know whether the beta variable is significant.  That can be obtained with the t-stat.  If the t-stat is great than or less than 2 it is significant. That is good!

And finally, we can comment on the validity of the regression with the R-squared statistic.  The statistic can be interpreted as the percentage of the variation in the Y variable that can be explained with the X variables.  Those that are new to regression analysis are frequently caught off guard by the low R-squared variable.  Regressions in the .2 to .4 range are very common and are not an indication of a poor model.  In fact, if you have a model that produced R-squared variable in the nineties, one should be concerned that there are other problems.  I will leave those issues to Wayne and Jerry, or even Oscar if you take a quant class.

Setting Hiring Standards--The bridge to Personnel Economics

Is it better to hire the best people, irrespective of cost, or is it it better to hire the cheapest irrespective of quality.

        Neither    In equilibrium:  w₁/q₁ = w₂/q₂

• The first ratio provides the cost to generate $1 in sales with an individual in category 1
• The general principle is stated in terms of ratios not levels
• Should the firm change its position if it has financial problems?  No!  Choosing the wrong labor mix will only make matters worse.
• Will foreign labor drive out American business because their labor is cheaper?  We do not care whether labor is les expensive, we care about whether it  is cost-effective.

Does the general principle work well with production that is independent across workers?

        Yes!

Does the general principle work well when the workers' productivity depends on the skills of others?

 

        Yes!  But you need to be careful how you define output as in my
         example with college grad proving on-the-job education for the HS
         grads.

Does the general principle work well with independent production across workers with workers that can use different types of capital?

        Yes!  But you will need to compare across labor groups AND
         across different types of capital.

        

How many should we hire?

    That is just the demand curve equilibrium:  MB  = MC

    MP_L x MR = MC

    MP_L x P    =  w   (In perfect competition)

Compensation:  How do we pay?

Start with the Economics stuff !

    Be sure that you understand what is Pareto Efficiency and how to determine the Pareto Efficient level of output.

    Be sure that you understand what is the rule if the worker was also the owner and how to determine the equilibrium level of
     output.

    Be sure that you understand what is welfare economics and how to determine the level of output that maximizes social
     welfare or economic well-being.     

Can we get to that level with a piece rate system, a salary system, or a quota system?
Be able to calculate the workers' benefit after effort costs and be able to calculate the the owners' profit.

Is it more beneficial to be in a piece rate system or quota system if you are a worker?  Can the firm charge the worker rent and improve their profitability?  When?