Labour Economics | What Is a Compensating Wage Differential?

We observe the phenomenon of a compensating wage differential on both perfect and imperfect markets. That term was coined by Adam Smith and has existed in economics since the end of the 18th centrury. In his famous work Wealth of Nations, Adam Smith has used it for explaining the necessity of compensating 'advantages and disadvantages' between various sorts of jobs for the sake of equilibrium which enables people to make a free choice.

Lunchtime on a Skyscraper: a Compensating Wage Differential

In labour economics, the existence of the compensating wage differential is represented by nondegenerate wage distribution due to different factors such as the level of risk, health hazards, available amenities, length of work etc. By that we mean that jobs are different, so some of them are better and some are worse remunerated. That can be attributed either to the efforts needed to accomplish them or by the conditions in which workers find themselves. For instance, the compensating wage differential is observed when workers receive more money for working extra hours or for being exposed to severe climatic conditions.

Last but not least, labour force itself is not homogenuous. The principle of the compensation wage differential can be seen when high-skilled and professional workers are paid more for carrying out more demanding jobs than those who do the menial jobs. Today many workers are paid efficient wages which are much higher than their reservation wage. That measure is aimed at improving the productivity of the labour force by motivating it with more generous remuneration.