Reference Dependence and Labor Market Fluctuations

Abstract

We incorporate reference-dependent worker behavior into a search-matching model of the labor market, in which firms have all the bargaining power and productivity follows a log-linear AR(1) process. Motivated by Akerlof (1982) and Bewley (1999), we assume that existing workers' output falls stochastically from its normal level when their wage falls below a "reference point", which (following Kőszegi and Rabin (2006)) is equal to their lagged-expected wage. We formulate the model game-theoretically and show that it has a unique subgame perfect equilibrium that exhibits the following properties: existing workers experience downward wage rigidity, as well as destruction of output following negative shocks due to layoffs or loss of morale; newly hired workers earn relatively flexible wages, but not as much as in the benchmark without reference dependence; market tightness is more volatile than under this benchmark. We relate these findings to the debate over the "Shimer puzzle" (Shimer (2005)).

Equilibrium Effects of Pay Transparency

“…Second, transparency could lead workers to experience low morale, and reduce effort or quit their jobs upon learning peers make more money (Akerlof and Yellen (1990), Card, Mas, Moretti, and Saez (2012), Cullen and Perez‐Truglia (2022), Perez‐Truglia (2020), Breza, Kaur, and Shamdasani (2018), Dube, Giuliano, and Leonard (2019), Cohn, Fehr, Herrmann, and Schneider (2014), Bracha, Gneezy, and Loewenstein (2015)). In the presence of morale concerns, we would expect an employer to equalize wages only if the productivity consequences from transparency were larger than the additional wage bill incurred; otherwise, the employer would rationally allow pay differences to continue (Eliaz and Spiegler (2013)). In follow‐up work, we discuss how bargaining forces may subsume morale concerns, leading wages to be equalized even when productivity consequences are small in comparison to the wage gap (Cullen and Pakzad‐Hurson (2022)).…”

Downward Rigidity in the Wage for New Hires

“…As a second example, continuing workers might have a reference point of their own past wage, and object to wage cuts because of morale. These considerations might matter less for new hires (Eliaz and Spiegler, 2014).…”

Habit formation and wage determination

“…5 5 Eliaz and Spiegler (2013) consider a search‐and‐matching framework, in which effort depends on a reference point, to provide a rationale for downward wage rigidity. The model can also be interpreted as efficiency‐wage set‐up.…”