Working Paper: CEPR ID: DP10288
Authors: Steffen Ahrens; Inske Pirschel; Dennis J. Snower
Abstract: We present a new theory of wage adjustment, based on worker loss aversion. In line with prospect theory, the workers? perceived utility losses from wage decreases are weighted more heavily than the perceived utility gains from wage increases of equal magnitude. Wage changes are evaluated relative to an endogenous reference wage, which depends on the workers? rational wage expectations from the recent past. By implication, employment responses are more elastic for wage decreases than for wage increases and thus firms face an upward-sloping labor supply curve that is convexly kinked at the workers? reference price. Firms adjust wages flexibly in response to variations in labor demand. The resulting theory of wage adjustment is starkly at variance with past theories. In line with the empirical evidence, we find that (1) wages are completely rigid in response to small labor demand shocks, (2) wages are downward rigid but upward flexible for medium sized labor demand shocks, and (3) wages are relatively downward sluggish for large shocks.
Keywords: downward wage rigidity; sluggishness; loss aversion
JEL Codes: D03; D21; E24
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| small labor demand shock (J23) | wage rigidity (J31) |
| medium labor demand shock (J23) | upward wage adjustment for positive shocks (J31) |
| medium labor demand shock (J23) | downward rigidity for negative shocks (E31) |
| large labor demand shock (J23) | downward sluggishness (E32) |
| wage changes (J31) | employment levels (J23) |
| reference wage (J31) | perception of wage losses and gains (J31) |