Wage compression

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).

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.