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Reservation Wages and the Wage Flexibility Puzzle

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  • Felix Koenig
  • Alan Manning
  • Barbara Petrongolo

Abstract

Wages are only mildly cyclical, implying that shocks to labour demand have a larger short-run impact on unemployment rather than wages, at odds with the quantitative predictions of the canonical search model - even if wages are only occasionally renegotiated. We argue that one source of the wage flexibility puzzles is plausibly the model for the determination of reservation wages, and consider an alternative reservation wage model based on reference dependence in job search. This extension generates less cyclical reservation wages than the canonical model, as long as reference points are less cyclical than forward-looking components of reservation wages such as the arrival rate of job offers. We provide evidence that reservation wages significantly respond to backward-looking reference points, as proxied by rents earned in previous jobs. In a model calibration we show that backward-looking reference dependence markedly reduces the predicted cyclicality of both wages and reservation wages and can reconcile theoretical predictions of the canonical model with the observed cyclicality of wages and reservation wages

Suggested Citation

  • Felix Koenig & Alan Manning & Barbara Petrongolo, 2016. "Reservation Wages and the Wage Flexibility Puzzle," CEP Discussion Papers dp1406, Centre for Economic Performance, LSE.
  • Handle: RePEc:cep:cepdps:dp1406
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    1. Reservation Wages and the Wage Flexibility Puzzle
      by maximorossi in NEP-LTV blog on 2016-02-29 19:59:32

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    Cited by:

    1. Samuel Bentolila & J. Ignacio García-Pérez & Marcel Jansen, 2017. "Are the Spanish long-term unemployed unemployable?," SERIEs: Journal of the Spanish Economic Association, Springer;Spanish Economic Association, vol. 8(1), pages 1-41, March.
    2. Samuel Bentolila & J. Ignacio García-Pérez & Marcel Jansen, 2017. "Are the Spanish Long-Term Unemployed Unemployable?," Working Papers wp2018_1707, CEMFI.

    More about this item

    Keywords

    job search; reservation wages; wage cyclicality; reference dependence;

    JEL classification:

    • J63 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Turnover; Vacancies; Layoffs
    • J64 - Labor and Demographic Economics - - Mobility, Unemployment, Vacancies, and Immigrant Workers - - - Unemployment: Models, Duration, Incidence, and Job Search
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity

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