Wage Dispersion (2) Compensating Differentials

Question 1

What assumptions are made for compensating differentials?

2 assumns

Answer 1

All workers are homogeneous

Labour market is perfectly competitive

Question 2

How are jobs characterised under compensating differentials?

Answer 2

Characterised by the wage (w) and amenities (a) (non-monetary characteristics)

Question 3

Define the Marginal Willingness to Pay for an amenity?

Answer 3

The amount that a worker would accept in terms of a wage cut in order to make them indifferent between their current job and another job with a low quantity of amenity

Question 4

What is the formula for the MWTP?

Explain verbally

Answer 4

MWTP(w,a) = [du/da (w,a) / du/dw (w,a)]

= u’(a)/u’(w)

I.e. = the marginal utility w.r.t. the amenity / marginal utility w.r.t wage

Question 5

Give the equation for the firms profit

Answer 5

π = p – w – c(a)

Question 6

What would the amenity costs be when:

i) Firms are homogeneous
ii) Firms are heterogeneous

Answer 6

i) c’(a) = MWP(w, a)

ii) cj’(a) = MWP(w,a) for each firm j

Question 7

When can there be wage (and amenity) dispersion in equilibrium?

Answer 7

when firms are heterogeneous

Question 8

What is the marginal rate of substitution (formula and verbal eexplanation)(

Answer 8

MRS = MWTP = c’(a)

Question 9

Why is there no wage dispersion in equilibrium when firms are homogeneous?

Answer 9

Because all firms are on the same zero profit curve, which is tangential to the workers indifference curve at only one point

Question 10

Draw indifference and cost curves for each case where

i) Firms are homogeneous
ii) Firms are heterogeneous

Answer 10

Amenity on x-axis, wage on y-axis

Cost curves are concave, indifference curves convex

Firms always look to move S-W

Homogeneous: One cost curve and one equilibrium point

Heterogeneous: Several different cost curves, each with their own equilibrium point on the same indifference curve

Question 11

What does the crucial assumption of a perfectly competitive labour market also implicitly mean?

Answer 11

That there are no frictions faced by firms in terms of searching / moving between jobs / employees

Question 12

Give an example of a hedonic wage regression

Answer 12

ln(wi) = xi’β + ai’ϒ + ηi

where x’ (a’) denotes “any observed characteristic (amenity)”

Question 13

What 4 conditions are required for the OLS estimate of the coefficient on (ai’) in the hedonic wage regression to be unbiased?

Answer 13

• Homogenous workers
• No measurement error of (w, a)
• (x) and (a) are separable i.e. observed characteristics do not impact the workers MWTP for the amenity
• the labour market is perfectly competitive

Question 14

If the estimate of the coefficient on (a’) in a hedonic wage regression is unbiased then how can it be interpreted?

(2 points)

Answer 14

It is -MWP(w,a)

i.e.

MWP(w,a) = -ϒ(hat)

Question 15

Why are the amenity and wage negatively correlated?

2 points

Answer 15

Because people in jobs with better amenities will be paid less

i.e. to compensate for worse amenities workers demand a higher wage

Question 16

What 3 things should you consider when looking at hedonic wage regression data?

Answer 16

Coeff sign

Coeff magnitude

Coeff significance

Question 17

If the coefficient on an an amenity is negative, significant and large then what inference can you make?

Answer 17

As it is significant it seems that workers care about the value of the amenity

The workers MWTP for the amenity is positive

As it is large, they care a lot about it

Question 18

What issues can occur with hedonic wage regressions?

Answer 18

Violation of any one of the 4 assumptions can lead to biased estimates