A compensating differential, which is also called a compensating wage differential or an equalizing difference, 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.
[2][12] The theory of compensating wage differentials, by Adam Smith, provides a theoretical framework of the ideology behind pay differences.
[13] Competition in labour markets ensures that the net advantages of different jobs will tend to equality.
The pay offered in this area is set to counter the relative unattractiveness of the region.
On the contrary, if an employer offers a health insurance plan with low coverage that is not attractive to employees, the wages at the firm will likely not be reduced due to the low participation in the health insurance plan.
In this scenario, employees would prefer to receive higher wages and lower quality benefits.
[14] The hedonic wage function represents the assumption that employees maximize their utility in job selection to a budget constraint outlined by the labor market.
[15] The function is upward sloping due to the parallel relationship between wages and the undesirable qualities of a job; the more undesirable the job is, the higher the wages employees are compensated for working at the company.
[16] Most of the empirical results from the literature attempt to decompose the geographical wage differentials according to human capital characteristics.
[17] In 1992, Reilly[18] used this decomposition technique[17] to decompose wage differentials between 6 local labour markets in the UK.
This give some extra evidence that wage differentials compensate, at least partly, for geographical differences in cost-of-living.
They simply refer to differences in total pay (or the wage rate) in any context.
In the theory of price indices, economists also use the term compensating variation, which is yet another unrelated concept.