Wage compression

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Wage compression refers to the empirical regularity that wages for low-skilled workers and wages for high-skilled workers tend toward one another. As a result, the prevailing wage for a low-skilled worker exceeds the market-clearing wage, resulting in unemployment for low-skilled workers. Meanwhile, the prevailing wage for high-skilled workers is below the market-clearing wage, creating a short supply of high-skilled workers (and thus no unemployment of high-skilled workers).

Perfectly competitive labour markets can still exhibit a wage compression effect. In a perfectly competitive market, workers of different skill levels receive different wages and workers of the same skill level will receive the same wage no matter which firm they work in. However, the distribution of the skills of employees may be wider than the distribution of their wages.[1]

Akerlof and Yellen (1990) propose a model that uses the fair-wage hypothesis to explain wage compression. The fair-wage hypothesis suggests that the effort put forth by a worker is proportional to the fairness of her wage, as compared to other workers within the firm. Accordingly, if executives of a given firm are compensated much more highly than the firm’s unskilled workers, the unskilled workers will exert a lower level of effort. In equilibrium, high-skilled wages tend downward, while low-skilled wages tend upward, which defines wage compression.[2]

Moene and Wallerstein (2006) argue that intentional wage compression led to a shift in favour of higher-productivity industries in Scandinavia, as it made low productivity industries less profitable and high productivity industries more profitable.[3]

Companies that experience salary compression are more likely to experience salary compression with less experienced new or existing employees than with more experienced tenured employees.

Causes[]

Historically, wage compression tends to occur when employees in identical jobs (e.g. Financial Analysts) are paid wages based on a broad range, instead of having a designated pay range for each level of a position (e.g. Financial Analyst - Level 1 [Year 1], Financial Analyst - Level 2 [Year 2], etc). Furthermore, wage compression is particularly prevalent when the wages of an organisations current employees don't proportionally mimic the increases in an industries average wage rate.[4] Hence, these scenarios may result in:

  • The remuneration packages of new employees is equal to that of an experienced employee, in an identical job position level (i.e., when the wages of less experienced employees are equal to the wages of experienced employees).
  • The remuneration packages of junior staff are approximately equal to those of senior staff, in an identical job position (i.e., when the wages of low-level employees are approximately equal to the wages of high-level employees).

Wage compression is a result of numerous underlying issues, all of which tend to transpire over a period of years. These issues may have varying effects on firms, employees and the overall economy, especially in times of high economic uncertainty.

Minimum wage increases[]

Increases in minimum wage tends to result in junior (low-skilled) workers being overpaid relative to their senior (high-skilled) peers. Furthermore, senior employees may be underpaid relative to their junior peers. Thus, increases in minimum wage may result in the wage gap narrowing.

Status[]

Frank (1984) proposed that a cause of wage compression is a trade off between status and wages. He argues that both status and wages are tradeable material goods which workers value. Higher skilled workers receive greater status in exchange for receiving a wage lower than the market clearing wage. Lower skilled workers receive a wage higher than the market clearing wage in exchange for receive less status.[1]

Similarly, Cabrales et al. (2008) proposed that lower level employees experience disutility from working with higher level employees and would prefer to work in a more equal firm. Because of this, lower level employees must be compensated in order to convince them to work with higher level colleagues. Lower level workers receive extra wages which are uncorrelated with their productivity, leading to wage compression.[1]

Training[]

Almeida-Santos and Mumford (2005) found that firms with higher levels of wage compression are most likely to cover the costs of employee training.[5] However, this study focused on wage compression within certain occupations rather than within individual firms. Pfeifer (2016) focused on individual firms and found that organisations with greater intra-firm wage compression are more likely to cover training costs than firms with less wage compression.[6] It can be argued that one cause of increased wage compression is the fact that higher skilled workers do not have to pay for certain training costs using their own funds.[5]

Effects[]

Firms[]

If wage compression is present, firms will likely exhibit changes in employee sentiment, in regards to: effort, responsibility, motivation and loyalty.

  • Effect on skillset: If low-skilled (junior) employees are paid relatively equal to their high-skilled (senior) peers, then there is less incentive for more experienced employees to strive for promotion. Employees would prefer to decrease their workload and take on less responsibility, while earning a similar wage to their senior peers.
  • Effect on Turnover: If firms are incentivising new junior (low-skilled) employees with higher remuneration packages, then current employees (particularly high-skilled workers) may feel undervalued and thus, will be incentivised to look for new employment opportunities.
  • Effect on firm's performance: If workers feel undervalued and unmotivated to strive for greater results, this will have a negative effect on the firm's performance, in terms of profitability and other aspects.

Unions[]

Some unions may view wage compression as desirable because it can decrease large wage disparities within certain professions, and arguably promotes equality. Wage compression is viewed by some as a reform strategy which should be encouraged because it brings the pay of high level employees like senior executives closer to the pay of lower level employees.[7]

Low-skilled employees[]

Firms which experience wage compression usually value higher-skilled workers more, because they have a higher level of productivity relative to their wages. In contrast, lower-skilled employees are paid a wage higher than the wage which would correlate with their productivity. Because of this, firms that need to reduce wage costs or decrease the number of employees will prefer to fire low-skilled workers. Consequently, wage compression can decrease the job security of lower-skilled employees.[8]

References[]

  1. ^ a b c Cardoso, Ana Rute (July 2009). "Do firms compress the wage distribution?" (PDF). Institute for Economic Analysis (IAE-CSIC) and IZA Bonn.
  2. ^ Akerlof, George A; Yellen, Janet L (1990). "The fair wage-effort hypothesis and unemployment". The Quarterly Journal of Economics. 105 (2): 255–283. doi:10.2307/2937787. JSTOR 2937787.
  3. ^ Moene, Karl Ove; Wallerstein, Michael (2006). "The Scandinavian model and economic development" (PDF). Development Outreach. 8 (1): 18–21. Retrieved 2020-08-13.
  4. ^ Seaman, Scott (2007-09-01). "Estimating Salary Compression in an ARL Institution: A University of Colorado at Boulder Case Study". College & Research Libraries. 68 (5): 388–404. doi:10.5860/crl.68.5.388. ISSN 2150-6701.
  5. ^ a b Almeida-Santos, Filipe and, Karen, Mumford (June 2005). "Employee Training and Wage Compression in Britain". The Manchester School. 73 (3): 321–342. doi:10.1111/j.1467-9957.2005.00449.x. hdl:10419/20443.
  6. ^ Pfeifer, Christian (March 2016). "Intra-Firm Wage Compression and Coverage of Training Costs: Evidence from Linked Employer-Employee Data". ILR Review. 69 (2): 435–454. doi:10.1177/0019793915610307.
  7. ^ Plass, Stephen (2016). "Wage Compression as a Democratic Ideal". Cornell Journal of Law and Public Policy. 25 (3): 601–647.
  8. ^ Zoega Gylfi, Karlsson Thorlakur (28 March 2006). "Does wage compression explain rigid money wages?" (PDF). Economics Letters. 93: 111–115. doi:10.1016/j.econlet.2006.03.043.
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