Wage differentials

What is a wage differential?

A wage differential is the difference in pay between workers in different occupations, industries, regions or groups (for example men and women). Differentials are measured in euro per hour, or as a percentage.

Some differentials are easy to justify: a surgeon has trained for over ten years and carries enormous responsibility. Others are harder to explain. Economists sort the causes into four groups:

1. Supply and demand for each type of labour (how many people can do the job and how much employers want them).

2. Compensating differentials: extra pay for unpleasant, dangerous or inconvenient work.

3. Human capital: extra pay for skills, education, training and experience.

4. Labour market imperfections: trade unions, immobility of labour, discrimination and monopsony power.

The first three are consistent with a well-functioning market. The fourth explains pay gaps that are not about productivity at all.

Wages in Ireland also differ because the Central Statistics Office (CSO) data show that average earnings in information and communication or finance are well above those in accommodation and food. That is a differential between sectors.

Compensating differentials and human capital

Compensating differentials

A job may be dangerous, unsociable or stressful. Few people will do it unless the pay is higher. The extra pay compensates the worker for the non-monetary disadvantages of the job.

Examples: offshore wind-farm technicians, night-shift allowances for nurses, Garda overtime, and fishing crews on the west coast. The opposite also happens: a job with high satisfaction, such as being a musician or working in a sports club, may pay less because many people want it.

Human capital

Human capital is the stock of skills, knowledge and experience in a worker. Education and training make a worker more productive, so their marginal revenue product (MRP) is higher and employers will pay more. Workers invest in human capital because it raises future earnings, but it has a cost: fees and, above all, earnings given up while studying. That is an opportunity cost.

Knowing a worker's MPP and MRP is useful to both sides. An employer can compare the MRP of a worker (MPP × MR) with the wage to decide whether hiring or training someone adds more to revenue than to cost. A worker can use it to argue for higher pay, or to see which skills raise MRP. But it has limits: MPP is hard to measure in teams or in public services, and MRP depends on the product price as well as on the worker, so it is an imperfect guide to pay.

Supply and demand in different labour markets

Every occupation has its own labour market, with its own demand curve (from employers) and its own supply curve (from workers). The wage in each is where they cross. Differentials appear when the curves differ.

• Demand for labour is a derived demand: it depends on the MRP of the worker, which depends on productivity and on the price of the product the worker helps to make. MRP = MPP × MR, where MPP (marginal physical product) is the extra output from one more worker and MR is the extra revenue from selling one more unit.

• Supply depends on the training required, the qualifications needed, the number of people willing to do the job and the non-monetary features of the job.

In A, supply is steep (inelastic) because four years of training are needed, and demand is strong, so the wage is high. In B, almost anyone can do the job, so supply is flat (elastic); the wage is held down. If more people train for A, the supply curve in A shifts to the right and the wage in A falls, while B is unchanged.

Labour market imperfections

Real labour markets are not perfectly competitive. Three imperfections (monopsony is covered in the next section) can widen or maintain differentials beyond what productivity explains.

Trade unions

A trade union bargains collectively and can raise wages above the equilibrium. This creates a differential between unionised and non-unionised workers. But there is a cost: at the higher wage, employers demand less labour, and more people want to work.

Immobility of labour

Workers may not move easily between jobs or places. Occupational immobility: a bricklayer cannot become a data analyst overnight. Geographical immobility: house prices, family ties and the lack of public transport can keep people in an area. If labour does not flow from low-wage to high-wage areas, differentials persist, for example between Dublin and the border counties.

Discrimination and the gender pay gap

Discrimination means that workers with equal productivity are paid differently because of gender, age, ethnicity, disability or other characteristics. The gender pay gap is usually measured as:

A gap does not automatically prove discrimination. Productivity-based explanations: differences in hours, experience, career breaks or occupation chosen. Discrimination-based explanations: unequal pay for the same work, the glass ceiling (barriers to promotion) and undervaluing of occupations dominated by women. Policies include pay transparency and reporting rules, affordable childcare and parental leave for both parents, and equal pay legislation. Each has limits: reporting does not by itself change pay, childcare is costly for the State, and discrimination is difficult to prove.

Monopsony: when the employer has the power

In a perfectly competitive labour market, a firm is a wage taker. A monopsony is a market with a single dominant buyer of labour, for example the only large factory in a small town. Because the firm is the main employer, it faces the whole upward-sloping labour supply curve, and to hire an extra worker it must offer a higher wage to all workers. So the marginal cost of labour (MCL) is greater than the wage.

The firm hires until $MRP = MCL$ and then pays the wage the supply curve requires at that level of employment.

The three lines are MRP (falling), labour supply and MCL (the steepest rising line). Find where MRP meets MCL, then go to the supply line to read the wage.

Vuelve al principio: Ciara earns more than Cian because her job is risky and unsocial (compensating differential), because she needed training (human capital), and because supply of qualified technicians is limited while demand is growing. Imperfections such as unions, immobility or discrimination might widen or narrow the gap further, so the differential is not entirely about productivity.

Summary