Monday, 18 November 2013

Compensating differentials, psychic payoffs, and the Oswald Hypothesis

In my ECON110 Economics and Society class we cover labour markets. One of the key aspects is that, based on the basic theory, the wages in different labour markets should be the same. The intuition that leads to that conclusion is simple: If labour is mobile and there are no costs of moving, and if there were labour markets with different wages, then workers would move from the low wage market to the high wage market. This would increase the supply of workers in the high-wage labour market, lowering wages there, and decrease the supply of workers in the low-wage labour market, raising wages there. This would continue until the two markets have the same wage.

Using that as a starting point, we then discuss why that doesn't happen in the real world. There are a number of fairly intuitive and fairly obvious reasons, usually relating to differences in supply and/or demand in the markets. In this post though, I only want to concentrate on one explanation: compensating differentials. Some jobs have desirable characteristics, while other jobs have undesirable characteristics. Jobs with desirable characteristics attract more workers, increasing labour supply and lowering wages relative to jobs with undesirable characteristics. In other words, workers are compensated (with higher wages) for undertaking jobs that have undesirable characteristics. The standard example I use is welders - on oil rigs, welders can earn several times higher salaries than they can onshore. They are essentially being compensated for a number of undesirable characteristics of the job though - long hours, high stress environment, long periods away from family, and higher risk of death or injury.

The textbook treatment of compensating differentials usually tends to focus more on negative characteristics (as I have above). Positive job characteristics are typically explained as the inverse of negative job characteristics. However, jobs may provide non-monetary or emotional rewards (so-called "psychic payoffs"). These arise where the worker receives utility or satisfaction from doing the job, over and above any monetary wages they receive. A 2012 paper in the journal Kyklos (gated) by William Baumol and David Throsby does a good job of explaining how these psychic payoffs work and their implications in the context of sports and the arts.* In their basic model, Baumol and Throsby describe how the existence of psychic payoffs leads to systematic underpayment of workers (a classic compensating differential as described above, but in this case a positive one).

However, I thought the more interesting implication of their paper occurred when they relaxed the assumptions so that labour was no longer completely mobile. When sports stars (or actors, dancers, etc. in the case of the arts) become emotionally attached to a team, they are less willing to move elsewhere. This gives the team some additional monopsony power in salary negotiations, and lowers the resulting wage (leading to 'underpaid' superstars). Again, this is a compensating differential, but the mechanism through which it arises is different (it arises indirectly because of the reduced mobility, rather than directly through the job characteristics themselves). Because this effect arises indirectly, it can be caused not only by positive job characteristics (such as a superstar's attachment to their team), but also through characteristics of the labour market (such as contract terms, etc.). There is evidence to support this, with superstars being paid much less than their contributions to team revenues, such as here (ungated version here).

Reduced mobility of labour has other effects on the labour market as well. My colleagues Bill Cochrane and Jacques Poot presented their research on the Oswald Hypothesis at the recent Pathways conference. This hypothesis argues that areas of high home ownership have higher unemployment, because home owners face high transaction costs associated with selling their home, which makes it difficult to move and take up available jobs elsewhere (or alternatively, they could be reluctant to move because they are emotionally attached to the neighbourhood they live in, leading to an additional psychic cost of moving). As with compensating differentials, this suggests that the supply curve for labour would not fully adjust to bring different labour markets into equilibrium (similar to the case of compensating differentials above). Bill and Jacques showed that the hypothesis appears to hold for New Zealand, with areas of higher unemployment having higher home ownership rates (to the extent that a 10 percent higher home ownership rate was associated with 2.8 percent higher unemployment). Of course, there analysis does not demonstrate causality, despite media reports that purport otherwise. They are not alone in continuing to investigate the hypothesis and demonstrate that home ownership and unemployment are correlated - Andrew Oswald himself (along with David Branchflower) has a new working paper based on U.S. data. Their new paper was recently discussed in some detail by Ken Gibb.

So, compensating differentials, psychic payoffs, and the Oswald Hypothesis all lead us to conclude that labour markets are somewhat inflexible.


* The Baumol and Throsby paper is interesting as well because it addresses what happens when there are psychic payoffs to capital (such as to team owners) as well as to labour.

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