According to compensating differentials theory, two jobs that are identical except that one involves significantly higher fatality risk should have...
AIdentical wages because wages depend only on productivity
BHigher wages for the dangerous job to compensate workers for accepting the additional risk
CLower wages for the dangerous job because dangerous jobs attract less-qualified workers
DWages determined entirely by union bargaining power
Compensating differentials predict that workers require a wage premium to accept undesirable job attributes like fatality risk. If the dangerous job did not pay more, no worker (holding other attributes constant) would voluntarily choose it over the safe alternative. The premium is the 'compensating differential' — the additional pay that compensates for the disamenity. Empirical estimates suggest the value of a statistical life (VSL) implied by compensating differentials for fatality risk is approximately $7-12 million in the US.
Question 2 True / False
Compensating differentials theory predicts that all workers agree on which job attributes are desirable and require identical compensation for disamenities.
TTrue
FFalse
Answer: False
A key feature of the hedonic model is preference heterogeneity. Workers differ in their tolerance for risk, their valuation of flexibility, and their distaste for unpleasant conditions. Workers with high risk tolerance sort into dangerous jobs at relatively lower premiums, while risk-averse workers sort into safe jobs and forego the premium. The observed market wage differential reflects the marginal worker's valuation — not every worker's identical valuation. This sorting is central to the hedonic equilibrium and explains why the observed premium may understate some workers' willingness to pay for safety.
Question 3 Short Answer
Why is empirically estimating compensating wage differentials challenging?
Think about your answer, then reveal below.
Model answer: The main challenges are: (1) omitted variable bias — unobserved worker quality may be correlated with job characteristics (if less-skilled workers end up in dangerous jobs, the negative correlation between skill and danger biases the compensating differential downward or even reverses its sign); (2) measurement of job attributes is imprecise (risk data are often measured at the industry rather than occupation level); (3) worker sorting based on unobserved preferences creates selection bias; and (4) labor market frictions (limited mobility, imperfect information) may prevent full equilibration.
These challenges explain why early empirical studies sometimes found negative compensating differentials for danger (dangerous jobs paying LESS), which contradicts the theory. The resolution is usually omitted variable bias: dangerous jobs may also tend to be low-skill jobs, and failing to control for skill differences allows the negative skill-wage relationship to mask the positive risk-wage relationship. More careful studies with better controls and occupation-level risk data generally find positive compensating differentials consistent with theory.