Wage differentials

If labour markets are very competitive, with identical workers and perfect mobility of labour, wages will move towards the same equilibrium level. However, in reality wages can differ greatly, even for the same job. A variety of different factors account for this, including the following.

Human capital differences

Some jobs require lengthy training and education, and this is reflected in higher wages. Human capital is the quantity and quality of labour and human capital development is the process of improving the quality of labour through education and training.

Human capital development, through education and training, is a considerable cost to individuals and firms, both in terms of time spent and resources used. Firms are aware that they must compensate for human capital development to attract the necessary skilled labour they require. Airlines, for example, know that they must pay skilled pilots significantly more than semi-skilled cabin crew to compensate pilots for the greater sacrifice pilots make during their lengthy education and training. In contrast, airlines only need to pay a relatively low wage to unskilled cleaners because there is little education or training needed, and therefore, little human capital development.

Over time, market forces will adjust the cost and benefit of education and training so that labour shortages in one area push up the wage rate, and it becomes more worthwhile to train for jobs in these shortage areas.

Formal education

Formal education is an important determinant of human capital, and wages. Lifetime earnings vary directly with education and an individual who just obtains ‘A’ Levels, will earn much less, on average, than an individual with a university degree.

Wages and skills

The demand for skilled workers is greater than the demand for unskilled workers because the value of the output produced by skilled workers will be higher, and can command a higher price.

The marginal cost of acquiring a skill and improving human capital is greater, so the skilled worker’s supply curve is to the left of the unskilled worker. The combined effect of the higher demand and lower supply is that wages for skilled workers are often much higher that for unskilled workers.

Because of the greater human capital required, skilled workers expect a higher wage to encourage them to supply more labour.

The widening pay gap

In the UK, the gap between the earnings of skilled and unskilled workers has risen in recent years, mainly for two reasons:

Technological change and the new economy have increased the productivity of many skilled workers. The application of IT is often more possible in skilled occupations compared with unskilled ones.
International trade and globalisation have had a significant downward impact on the pay of the unskilled. In contrast, the skilled, especially those in the service sector, are generally less adversely effected by global competition. The recent financial crisis has meant that the financial services sector has experienced difficulties in terms of pay, but the skills gap and resultant pay gap is unlikely to narrow in any significant way.

Discrimination

Wage levels can also be affected by job discrimination, which means that groups of worker are denied access, or have limited access, to jobs or to higher paid (elite) jobs. Workers can suffer discrimination because of their:

Gender
Race
Disability
Age

Discrimination is considered a labour market failure, and its effect is to reduce the supply of labour into a given profession, and drive up the pay of the elite workers. This leads to a relative increase in supply of workers available for the non-elite jobs and depresses their wages. Wage differentials can, therefore, be sustained by the practice of discrimination.

Labour market segmentation

Labour market segmentation refers to the tendency for modern labour markets to be composed of smaller sub-markets, rather than being one homogeneous market from which all firms hire their labour – which is the traditional, neo-classical, view of labour markets. In contrast, segmentation theory stresses that labour markets are composed of a set of differentiated sub-markets. Although individuals in different sub-markets may seek work in the same industry, each sub-market has very different characteristics. In addition, it may not be easy for individual workers to move from one sub-market to another.

Primary and secondary labour markets

Two particular sub-sectors have been widely studied, and form part of is called dual labour market theory. The primary labour market is composed of full-time workers, with permanent employment contracts, receiving higher pay and having better job security. Employers tend to be larger and provide good working conditions, better training, and offering greater chances of promotion. In contrast, the secondary labour market is more informal, with less job security, lower pay and little prospects of promotion.

Segmentation theory can provide a useful insight into inequalities of opportunity and outcome in the labour market – especially in terms of pay differentials – and discrimination in the labour market. It can also provide an explanation of differences in productivity between different sub-markets, as well as providing insights into the phenomenon of in-work poverty levels.

Read more on labour market discrimination

Gender and pay

Despite equal pay legislation, gender still affects wage rates. Even though the pay gap between men and women is closing, women still earn approximately 75 – 80% of the level of men.

Factors that might account for this gap include:

Possible differences in the level of human capital development, especially formal education because women may invest less in their own human capital development than men.
There may be productivity differences (in manual work), although this is clearly a minor factor in a service sector economy.
The number of hours worked, and career breaks will affect labour productivity. On average, women work fewer hours than men (35 hours per week, for women and 40 hours for men. It is estimated that this alone contributes around 12.5% of the difference). (Source: OECD)
Women are often crowded into low-paid jobs, with low skill levels.
Women are also often crowded into part-time jobs, with lower pay relative to full-time employees.
In contrast, women are often crowded out of higher paid jobs through discrimination, or are discriminated against in terms of promotion. Females often make up a very small percentage of senior jobs.

Female pay as a percentage of male pay has been rising over the last 15 years. Despite the differences that still exist, the gap between male and female pay is narrowing.

Go to wages and employment under monopsony

Wage differentials