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A theory of wage setting behavior

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  • Marco Fongoni

    () (Department of Economics, University of Strathyclyde)

  • Alex Dickson

    () (Department of Economics, University of Strathyclyde)

Abstract

Concerns for fairness, workers' morale and reciprocity influence firms' wage setting policy. In this paper we formalize a theory of wage setting behavior in a simple and tractable model that explicitly considers these behavioral aspects. A worker is assumed to have reference-dependent preferences and displays loss aversion when evaluating the fairness of a wage contract. The theory establishes a wage-effort relationship that captures the worker's reference-dependent reciprocity, which in turn influences the firm's optimal wage policy. The paper makes two key contributions: it identifies loss aversion as an explanation for a worker's asymmetric reciprocity; and it provides realistic and generalized microfoundation for downward wage rigidity. We further illustrate the implications of our theory for both wage setting and hiring behavior. Downward wage rigidity generates several implications for the outcome of the initial employment contract. The worker's reference wage, his extent of negative reciprocity and the firmsÃÆ'¢â‚¬â„¢ expectations are key drivers of the propositions derived.

Suggested Citation

  • Marco Fongoni & Alex Dickson, 2015. "A theory of wage setting behavior," Working Papers 1505, University of Strathclyde Business School, Department of Economics, revised Feb 2016.
  • Handle: RePEc:str:wpaper:1505
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    More about this item

    Keywords

    reference dependence; loss aversion; morale; reciprocity; employment contract; downward wage rigidity; wage setting behavior;

    JEL classification:

    • C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory
    • J30 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - General
    • J41 - Labor and Demographic Economics - - Particular Labor Markets - - - Labor Contracts

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