Wage compression (also known as salary compression and pay compression)[1] 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.[2]
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.[3]
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.[4]
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.