Labor Economics

Summer 2018

2: Wage setting, labor market

discrimination and inequality

Prof. Dr. Almut Balleer

Chair for Applied Economics
RWTH Aachen
Wage Setting Inequality Labor Market Discrimination Summary

Compensating Wage Differentials

Almut Balleer Labor Economics: Topic 2 2

Wage Setting Inequality Labor Market Discrimination Summary

Wage setting

• The labor market is not characterized by a single wage:

workers differ and jobs differ
• Why do some workers earn different wages than others?
• Adam Smith proposed the idea that job characteristics
influence labor market equilibrium
• Workers have different preferences and firms offer different
working conditions
• Compensating wage differentials arise to compensate workers
for non-wage characteristics of the job: Health, job security,
etc.

Almut Balleer Labor Economics: Topic 2 3

Wage Setting Inequality Labor Market Discrimination Summary

Preferences for Risky Jobs

• Workers care about whether their job is safe or risky.

• Utility = U(wage, risk of injury).
Almut Balleer Labor Economics: Topic 2 4
Wage Setting Inequality Labor Market Discrimination Summary

Preferences for Risky Jobs

• The worker earns w0 and gets U0 if she chooses the safe job
• At w10 /w100 the worker prefers the safe/risky job
Almut Balleer Labor Economics: Topic 2 5
Wage Setting Inequality Labor Market Discrimination Summary

Preferences for Risky Jobs

• At ŵ1 the worker is indifferent between the risky and the safe job
• The workers reservation price is then given by ∆ŵ = ŵ1 − w0 .
Almut Balleer Labor Economics: Topic 2 6
Wage Setting Inequality Labor Market Discrimination Summary

Determining the Market Compensating Differential

• The supply of labor to risky jobs slopes up because as the wage gap
between the risky job and the safe job increases, more and more
workers are willing to work in the risky job.
Almut Balleer Labor Economics: Topic 2 7
Wage Setting Inequality Labor Market Discrimination Summary

Determining the Market Compensating Differential

• Firms may have a risky work environment because it is less

expensive to pay higher wages than to make the environment safe
• The demand curve slopes down: fewer firms offer risky working
conditions if they have to offer high wages for this
Almut Balleer Labor Economics: Topic 2 8
Wage Setting Inequality Labor Market Discrimination Summary

Hedonic Wage Theory

• Workers maximize utility by choosing wage-risk combinations
that offer them the greatest amount of utility
• Different workers may have different preferences for risk
(different indifference curves)
• Firms minimize costs by choosing the wage-risk combinations
that offer them highest profits/lowest costs
• Firms may have different possibilities to trade-off wages and
job risk (different isoprofit curves)
• Hedonic wage functions reflect the relationship between wages
and job characteristics.
• On the market, each firm finds the worker at the lowest
possible wage and each worker finds the firm at the highest
possible wage

Almut Balleer Labor Economics: Topic 2 9

Wage Setting Inequality Labor Market Discrimination Summary

The Hedonic Wage Function

• Matching workers who dislike risk with firms provide safe

environment at low cost (A and X)
• Matching workers who like risk with firms that provide safe
environment at high cost (C and Z)
Almut Balleer Labor Economics: Topic 2 10
Wage Setting Inequality Labor Market Discrimination Summary

Layoffs and Compensating Differentials

• Comparing two jobs with different hours: h1 refers to seasonal jobs,

high layoff probability
• Worker is indifferent only if low hours are compensated at higher
wage w1
Almut Balleer Labor Economics: Topic 2 11
Wage Setting Inequality Labor Market Discrimination Summary

The Wage Structure

Almut Balleer Labor Economics: Topic 2 12

Wage Setting Inequality Labor Market Discrimination Summary

The Wage Structure

• Why do some workers earn more than others?

• Human capital (skill)
• Productivity differences: different rate of return to different
skills
• Demand for skilled labor depends on substitutability with
unskilled labor and capital
• Human capital depends on ability, investment in human
capital, age, etc.
• Labor market and other economic institutions affect the
relative demand and supply of skill

Almut Balleer Labor Economics: Topic 2 13

Wage Setting Inequality Labor Market Discrimination Summary

The Wage Distribution in the US, 2012

• The wage distribution is positively skewed

• A small percent of workers earn disproportionately large shares of
the rewards for work.
Almut Balleer Labor Economics: Topic 2 14
Wage Setting Inequality Labor Market Discrimination Summary

What explains the earnings distribution

• Age distribution in the population: Young workers are still

accumulating human capital, while older workers are collecting
returns from earlier investments
• Different abilities explain different wages (even for same level
of human capital)
• Superstar wages, entrepreneurs, managers (?)
• Higher ability workers invest more in human capital, since the
returns from the investment are larger: There is a positive
correlation between ability and human capital investments,
which stretches out wages in the population.

Almut Balleer Labor Economics: Topic 2 15

Wage Setting Inequality Labor Market Discrimination Summary

What explains the earnings distribution

• Human capital investment can vary from worker to worker

(even for the same ability)
• High-income parents typically invest more in the education of
their children than do low-income parents.
• The quality of the environment where a child grows up helps
determine human capital (social capital)
• Quality of neighborhood
• Importance of religious organizations
• Socioeconomic background of classmates

Almut Balleer Labor Economics: Topic 2 16

Wage Setting Inequality Labor Market Discrimination Summary

Changes in the Wage Structure: The 1980s

Earnings Inequality for Full-Time, Year-Round Workers, 1963-2005: The 80-50 Wage Gap

• Wage gaps provide wage ratios between different percentiles in the

distribution: here between the 80th and the 50th percentile

Almut Balleer Labor Economics: Topic 2 17

Wage Setting Inequality Labor Market Discrimination Summary

Changes in the Wage Structure: The 1980s

Earnings Inequality for Full-Time, Year-Round Workers, 1963-2005: The 80-50 Wage Gap

• The wage gap between those at the top of the wage distribution
and those at the bottom widened dramatically.

Almut Balleer Labor Economics: Topic 2 18

Wage Setting Inequality Labor Market Discrimination Summary

Changes in the Wage Structure: The 1980s

Earnings Inequality for Full-Time, Year-Round Workers, 1963-2005: The 50-20 Wage Gap

• The wage gap between those in the middle and those at the bottom
did not change much
Almut Balleer Labor Economics: Topic 2 19
Wage Setting Inequality Labor Market Discrimination Summary

Changes in the Wage Structure: The 1980s

Earnings Inequality for Full-Time, Year-Round Workers, 1963-2005: The 80-50 Wage Gap

• Wage differentials widened within demographic groups

Almut Balleer Labor Economics: Topic 2 20

Wage Setting Inequality Labor Market Discrimination Summary

What explains increasing wage inequality?

• Inequality Across Generations

• If child earnings depend overproportionally on parents earnings,
the earnings differences would increase across generations
• If child earnings depend proportionally on parents earnings, the
earnings differences would stay the same across generations
• If child earnings depend underproportionally on parents
earnings, the earnings differences would decrease across
generations (supported empirically)
• Labor market and education policy affects dependency of child
earnings on parents earnings
• Over and above labor income, capital income could matter,
too

Almut Balleer Labor Economics: Topic 2 21

Wage Setting Inequality Labor Market Discrimination Summary

Changes in the Wage Structure: The 1980s

Wage Differential Between College Graduates and High School Graduates, 1963-2005

• Wage differentials widened across education groups

• At the same time, supply of skill increased dramatically (not shown
here)
Almut Balleer Labor Economics: Topic 2 22
Wage Setting Inequality Labor Market Discrimination Summary

Understanding the skill wage differential

• The downward-sloping demand curve implies that employers wish to

hire relatively fewer skilled workers when the relative wage of skilled
workers is high
• The perfectly inelastic supply curve indicates that the relative
number of skilled workers is fixed

Almut Balleer Labor Economics: Topic 2 23

Wage Setting Inequality Labor Market Discrimination Summary

Understanding the skill wage differential

• Suppose the relative supply of skilled workers increases

• The rising relative wage of skilled workers can then be explained
only if there was a sizable outward shift in relative demand

Almut Balleer Labor Economics: Topic 2 24

Wage Setting Inequality Labor Market Discrimination Summary

What explains increasing wage inequality?

• Increasing demand for skill

• Demand for skilled workers increased relatively more than
demand increased for unskilled workers
• Price-per quality of capital fell dramatically since the 1980s:
Increased demand for capital
• Increased physical capital demand helped to increase the
productivity of skilled workers: Capital-skill complementarity in
production
• No single factor explains the changes.
• The increase in inequality seems to be caused by concurrent
changes in economic fundamentals and labor market
institutions.

Almut Balleer Labor Economics: Topic 2 25

Wage Setting Inequality Labor Market Discrimination Summary

Labor Market Discrimination

Almut Balleer Labor Economics: Topic 2 26

Wage Setting Inequality Labor Market Discrimination Summary

Labor Market Discrimination

• Why do some workers earn different wages than others?
• Men earn more than women, and whites usually earn more
than nonwhites.
• Differences in educational attainment between whites and
nonwhites account for a portion of the wage differential
• Differences in occupation between males and females account
for a portion of the wage differential
• Discrimination occurs when the marketplace takes into
account such factors as race and sex when making economic
exchanges
• Racial/gender prejudice causes employers to blindly perceive
the costs of hiring blacks as being higher than the true cost

Almut Balleer Labor Economics: Topic 2 27

Wage Setting Inequality Labor Market Discrimination Summary

Labor Market Discrimination

The Trend in the Black-White Earnings Ratio, 1967-2012

Almut Balleer Labor Economics: Topic 2 28

Wage Setting Inequality Labor Market Discrimination Summary

Labor Market Discrimination

Trend in the Female-Male Earnings Ratio, 1960-2012

Almut Balleer Labor Economics: Topic 2 29

Wage Setting Inequality Labor Market Discrimination Summary

Employment without Discrimination

• If the market-determined black wage is less than the white wage, a

firm that does not discriminate will hire only blacks.
• Employment decision: Black wage equals the value of marginal
product of labor
Almut Balleer Labor Economics: Topic 2 30
Wage Setting Inequality Labor Market Discrimination Summary

Employment with Discrimination

• The discrimination coefficient d measure the cost the firm

associated with hiring black workers
• Firms that discriminate can be either white firms (high d) or black
firms (low d)
Almut Balleer Labor Economics: Topic 2 31
Wage Setting Inequality Labor Market Discrimination Summary

Employment with Discrimination

• Hire only whites if wB (1 + d) > wW ,

hire only blacks if wB (1 + d) < wW :
segregated workforce if workers are perfect substitutes
• Hire until wage equals the value of marginal product: Firms that
discriminate hire fewer workers than firms that do not discriminate.
Almut Balleer Labor Economics: Topic 2 32
Wage Setting Inequality Labor Market Discrimination Summary

Profits and Discrimination

• Discrimination reduces profits, even for black firms

Almut Balleer Labor Economics: Topic 2 33

Wage Setting Inequality Labor Market Discrimination Summary

Black/White Wage Ratio in Equilibrium

• Employer discrimination generates a wage gap between equally skilled black and
white workers.
• The quantity demanded for black labor increases as the black-white wage ratio
falls.
• The equilibrium black-white wage ratio is given by the intersection of supply and
demand
Almut Balleer Labor Economics: Topic 2 34
Wage Setting Inequality Labor Market Discrimination Summary

Black/White Wage Ratio in Equilibrium

• If more firms prefer to hire blacks, the demand curve shifts up

• The black-white wage ratio to exceed 1 if supply is small or demand for blacks is
large

Almut Balleer Labor Economics: Topic 2 35

Wage Setting Inequality Labor Market Discrimination Summary

Statistical discrimination

• Statistical discrimination is based on treating an individual on the

basis of membership in a group and knowledge of that groups
history.
• The workers wage depends not only on his own test score, but also
on the mean test score of workers in his racial group
Almut Balleer Labor Economics: Topic 2 36
Wage Setting Inequality Labor Market Discrimination Summary

Statistical discrimination

• If black workers, on average, score lower than white workers, a white

worker who gets a certain score earns more than a black worker with
the same score
• If the test is a better predictor of productivity for white workers,
high-scoring whites earn more than high-scoring blacks, and
low-scoring whites earn less than low-scoring blacks.
Almut Balleer Labor Economics: Topic 2 37
Wage Setting Inequality Labor Market Discrimination Summary

Summary

Almut Balleer Labor Economics: Topic 2 38

Wage Setting Inequality Labor Market Discrimination Summary

Summary

• Why do some workers earn different wages than others?

• Preferences and job characteristics
• Compensating wage differentials arise to compensate workers
for non-wage characteristics of the job: Health, job security,
etc.
• Workers have different preferences and firms offer different
working conditions
• Human capital
• Differences in abilities and investment
• Differences in demand for skill
• Discrimination
• Employer discrimination: Too high wages, too low employment

Almut Balleer Labor Economics: Topic 2 39