Compensation Differentials

Theory

In health services, the concept of compensation differentials is most commonly seen in discussions of employer-sponsored health insurance. The underlying concept is that if health insurance coverage is added to an employee's compensation bundle, then some other benefit will be reduced, such as money wages or pension. If this adjustment did not take place, the firm would find that it was paying more than the market clearing “price” for labor. People would be clamoring to work for the firm, and they would be willing to do so at a lower level of compensation. This argument is perfectly symmetrical. In an equilibrium labor market, if a firm decided to drop health insurance from its compensation bundle, it would have to increase some of the remaining elements in the bundle. Otherwise, current employees would resign to take jobs that offered better overall compensation.

Of course, the theory is based on equilibrium. If the demand for labor is rising, one would expect an employer to add something to the compensation bundle, be it a more generous health insurance package or more wages without removing other elements. Similarly, if the demand for labor is falling, the firm can reduce wages or cut health insurance benefits without adjusting the compensation bundle because workers are less likely to be able to find other employment.

The upshot of this theory is that workers pay for employer-sponsored health insurance in the form of lower wages and or reductions in other forms of compensation. This model has a number of implications. It implies, for example, that if a state were to require firms to provide health insurance for their workers, the workers would pay for this coverage in the form of lower wages or fewer other benefits. The theory suggests that there would be few unemployment effects unless wages could not be adjusted further downward, perhaps because of minimum wage laws. The theory also implies that if an employer were to reduce the coverage in its health insurance plan, perhaps by raising the copays for physician visits and prescription drugs, the employer would have to improve coverage in some other dimension. Employers would have to make workers whole, by raising wages, increasing pension contributions, or expanding other forms of compensation. If this is not done by the employer, many of the employees would seek employment elsewhere. With this theory, the price of employer-sponsored health insurance to the worker is not just the out-of-pocket premium; it is the out-of-pocket premium plus the wages and other benefits given up.

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