Compensating Wage Differentials and Work Conditions
"Heterogeneity" is the norm in labor market—there are always some distinct features among employees, jobs, and employers. Indeed, wage differences arise in large part due to heterogeneity, the inherent differences in labor demand (technology, skill demands), labor supply (personal characteristics and tastes), and the structure of the labor market. There is always going to be at least some "skill differential," differences in wage rates due to differing skill requirements of jobs. The great debate is the extent to which existing wage differences reflect only differences in skill requirements and skill demand. From an economic perspective, wage differentials serve a useful function of allocating labor, moving labor supply resources toward higher wage opportunities, which reflects a high demand and market value. Similarly, a wage differential steers labor suppliers away from jobs where wages are low or dropping. On the demand side, a growing wage induces employers to either use labor more resourcefully, restrain short-run labor costs, or implement new ways to improve labor productivity, to restrain labor cost in the long-run by getting the same amount of output from reduced labor input time.
Conditions of Work
One key way in which jobs differ, beyond skill requirements, is in their conditions of work, such as their safety risk and "amenities" (pleasant or attractive qualities). Jobs differ in their level of job security/insecurity, earnings stability/instability, job location, safety/injury, stress and health risk, employee benefits offered, flexible work schedules, shift work, wage trajectory in future, autonomy and control over workload, work pace, work process and on the job leisure (opportunities to engage in non-work activities while at the workplace). For adverse, poor or arduous working conditions, there should be a "positive" compensating wage differential or wage "premium," over and above the marginal revenue product of the position or skill level involved. Thus, we should expect that labor markets will provide a higher wage, all else constant, for jobs with obvious safety hazards, such as coal mining, nuclear power plant work, construction of skyscrapers, teaching in disadvantaged school districts, firefighting and law enforcement, or trash collection. The pay premium lures in people who might otherwise avoid such jobs. In addition, there is likely a positive compensating wage differential to compensate for necessary human capital investment costs up front, such as long or expensive training, preparation, and licensing requirements. This includes professional education such as medical and law school, and even professional sports training.
One of the consistent and interesting findings of the empirical research on wage differentials is that firm size matters, even when all other factors are controlled for. Larger firms pay higher wages than small firms—why might that be the case? Maybe workers at large firms are more productive? Do they provide better training or more advanced physical capital? Maybe more potentially productive workers are drawn to large sized workplaces or employers? Maybe also because large firms are more likely to be unionized or targeted by the labor movement for unionization drives? Perhaps higher wages in larger firms may be a compensating wage differential for tolerating some qualitatively different aspect of large employers' workplaces.
Efficiency Wage Models
A contributing role in creating wage differentials is played by "efficiency wages." Employers may purposely set and pay wages above either market wage rates for a job or even above the worker's own marginal revenue product. Why should an employer do this if they could incur lower labor costs by paying the lowest wage possible? One reason is that employers may be taking a longer or broader view of labor costs. Efficiency wage models have their roots in findings decades ago that paying workers better improved their nutrition, which in turned made them more productive. Similarly, the turnover model suggests firms will pay above-market wages in jobs or labor markets where recruiting hiring and training costs are high, to reduce or minimize turnover, which is costly in the longer run.
Why don't more employers adopt the cooperative, high-wage strategy to control their labor costs? Is it too counterintuitive? Are managers' "time horizon" too short-term to think about longer term labor costs? Might efficiency wage effects not be very long-lasting (diminishing returns as a managerial technique), particularly if there is lacking a climate of (mutual) trust in the workplace? Is there a "first-mover" disadvantage in purely competitive labor markets, for the firm that adopts this technique but others don't follow suit? Do managers have their own "utility functions" with a preference for managerial discretion (against power sharing) or compensation advantage over their subordinates?