Reservation Wages and the Wage Flexibility Puzzle

57 Pages Posted: 17 Feb 2016

See all articles by Felix Koenig

Felix Koenig

London School of Economics & Political Science (LSE)

Alan Manning

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP)

Barbara Petrongolo

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP); Centre for Economic Policy Research (CEPR); IZA Institute of Labor Economics

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Date Written: February 2016

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.

Keywords: job search, reference dependence, reservation wages, wage cyclicality

JEL Classification: E24, J31, J64

Suggested Citation

Koenig, Felix and Manning, Alan and Petrongolo, Barbara, Reservation Wages and the Wage Flexibility Puzzle (February 2016). CEPR Discussion Paper No. DP11109. Available at SSRN: https://ssrn.com/abstract=2733082

Felix Koenig (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Alan Manning

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP) ( email )

Houghton Street
London WC2A 2AE
United Kingdom
(44 20) 7955 6078 (Phone)

Barbara Petrongolo

London School of Economics & Political Science (LSE) - Centre for Economic Performance (CEP) ( email )

Houghton Street
London WC2A 2AE
United Kingdom
+44 20 7955 7799 (Phone)
+44 20 7955 7595 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

IZA Institute of Labor Economics

P.O. Box 7240
Bonn, D-53072
Germany

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