According to the basic theory of the labor market, there ought to be one equilibrium wage rate that applies to all workers across industries and countries. Of course this is not the case; doctors typically make more per hour than retail clerks, and workers in the United States typically earn a higher wage than workers in India. These wage differences are called compensation differentials and can be explained by many factors, such as differences in the skills of the workers, the country or geographical area in which jobs are performed, or the characteristics of the jobs themselves.
Education Differentials
One common source of differences in wage rates is human capital. More skilled and educated workers tend to have higher wages because their marginal product of labor tends to be higher . Additionally, the differential pay for more education tends to compensate workers for the time, effort, and foregone wages from obtaining the necessary training. If all jobs paid the same rate, for example, fewer people would go through the expense and effort of law school. The compensation differential ensures that individuals are willing to invest in their own human capital.
Education Differentials
Workers seek increased compensation by attaining higher levels of education
Geographic Compensation Differentials
If a certain part of a country is a particularly attractive area to live in and if labor mobility is perfect, then more and more workers will move to that area, which in turn will increase the supply of labor and depress wages. If the attractiveness of that area compared to other areas does not change, the wage rate will be set at such a rate that workers will be indifferent between living in areas that are more attractive but with a lower wage and living in areas which are more attractive with a higher wage. In this way, a sustained equilibrium with different wage rates across different areas can occur.
Discrimination and Compensation Differentials
In the United States, minorities and women make lower wages on average than Caucasian men. Some of this is due to historical trends affecting these groups that result in less human capital or a concentration in certain lower-paying occupations. Another source of differing wage rates, however, is discrimination. Several studies have shown that, in the United States, several minority groups (including black men and women, Hispanic men and women, and white women) suffer from decreased wage earning for the same job with the same performance levels and responsibilities as white males.
Compensating Differential
Not to be confused with a compensation differential, a compensating differential is a term used in labor economics to analyze the relation between the wage rate and the unpleasantness, risk, or other undesirable attributes of a particular job. It is defined as the additional amount of income that a given worker must be offered in order to motivate them to accept a given undesirable job, relative to other jobs that worker could perform. One can also speak of the compensating differential for an especially desirable job, or one that provides special benefits, but in this case the differential would be negative: that is, a given worker would be willing to accept a lower wage for an especially desirable job, relative to other jobs. .
Hazard Differential
Hazard pay is a type of compensating differential. Occupations that are dangerous, such as police work, will typically have higher pay to compensate for the risk associated with that job.