A theory of wage setting behavior

Research output: Working paper

Abstract

In this paper we provide a micro-foundation for wage rigidity in a simple and tractable model of wage setting behavior, inspired by a synthesis of recent convergent insights from anthropological and experimental research, and drawing on concepts advanced in the behavioral economics literature. The core principles underlying our theory are contractual incompleteness, fairness, reciprocity, and reference dependence and loss aversion in the evaluation of wage contracts by workers. The model establishes a wage effort relationship that captures a worker's asymmetric reference-dependent reciprocity, in which loss aversion implies effort responds more strongly to wage changes below the reference wage than above it. This basic relationship gives rise to wage rigidity around a worker's reference wage. We explore these implications further in a simple dynamic stochastic environment in which a worker adapts their feelings of entitlement once they become employed. The model allows us to shed new light on the importance of anticipated negative reciprocity and the cost of wage rigidity for a far sighted firm's hiring and wage setting behavior.
Original languageEnglish
Place of PublicationGlasgow
PublisherUniversity of Strathclyde
Pages1-55
Number of pages55
Volume15-05
Publication statusPublished - 17 Feb 2016

Publication series

NameStrathclyde discussion papers in economics

Keywords

  • reference dependence
  • loss aversion
  • reciprocity
  • morale
  • downward wage rigidity

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