Sometimes people intuitively understand compensating differentials

Today my ECONS102 class covered compensating differentials, in a topic on the labour market. A compensating differential explains why jobs that are otherwise similar might have different equilibrium wages. For example: consider two jobs that are similar in terms of skill requirements. If one of the jobs has positive non-monetary characteristics (e.g. it is safe, clean, and engaging), then more people will be willing to do that job. This leads to a higher supply of labour for that job, which leads to lower equilibrium wages. In contrast, if the other job has negative non-monetary characteristics (e.g. it is dangerous, dirty, and boring), then fewer people will be willing to do that job. This leads to a lower supply of labour for that job, which leads to higher equilibrium wages. The difference in wages between the attractive job that lots of people want to do and the unattractive job that fewer people want to do is called a compensating differential. The compensating differential essentially compensates workers for working in jobs with negative non-monetary characteristics compared with working in jobs with positive non-monetary characteristics.

Compensating differentials don't only apply to labour markets. As one example in a rental market, see this post. Another interesting example comes from this article in The Conversation last year by Andrew Vonasch (University of Canterbury):

If you’re offered a free cookie, you might say yes. But if you’re paid to eat a free cookie, would your response be the same?

In our new research, twice as many people were willing to eat a cookie when they weren’t offered payment compared with when they were...

Research participants who were offered a free cookie plus payment thought maybe the cookies were poisoned. Or maybe someone spat on them. Or they expected they would then owe a favour to the person handing out the treats once the cookie was eaten.

Vonasch claims that their research results reveal that the research participants were making irrational economic decisions, or that "people aren’t purely economic". However, that need not be true. A rational decision-maker who intuitively understands compensating differentials might respond in exactly the same way as Vonasch's research participants.

To see why, consider the choice that the research participants were offered. Eating a cookie is an enjoyable experience for most of us most of the time. Most of us wouldn't need to be paid to eat a cookie. So, if someone offers you a cookie and offers to pay you to eat it, it is natural to wonder what negative unobservable characteristics the payment is supposed to overcome. If there wasn't anything wrong with the cookie, why would they need to pay you to eat it? That is quite a rational response to the offer.

I often apply the same approach to thinking about salary offers in jobs (for example, see here). If a job is offering a much higher salary than other similar jobs, my first thought is always: what are the negative non-monetary characteristics that the extra salary is trying to compensate for? After all, who wants to live in South Waikato? Or rural Australia?

Compensating differentials are one of my favourite concepts in economics (and that's why there are so many regular posts on this blog about them). Interestingly, it appears that research participants who are offered payment to eat cookies understand them, even if they don't realise it!