A Theory of Wage Adjustment Under Loss Aversion

22 Pages Posted: 15 Jan 2015

See all articles by Steffen Ahrens

Steffen Ahrens

Technische Universität Berlin (TU Berlin); Kiel Institute for the World Economy

Inske Pirschel

Kiel Institute for the World Economy

Dennis J. Snower

University of Kiel - Institute for World Economics (IfW); Institute for the Study of Labor (IZA); Centre for Economic Policy Research (CEPR); CESifo (Center for Economic Studies and Ifo Institute)

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Date Written: December 30, 2014

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 sluggishness, loss aversion

JEL Classification: D030, D210, E240

Suggested Citation

Ahrens, Steffen and Pirschel, Inske and Snower, Dennis J., A Theory of Wage Adjustment Under Loss Aversion (December 30, 2014). CESifo Working Paper Series No. 5127, Available at SSRN: https://ssrn.com/abstract=2550096 or http://dx.doi.org/10.2139/ssrn.2550096

Steffen Ahrens

Technische Universität Berlin (TU Berlin) ( email )

Straße des 17
Juni 135
Berlin, 10623
Germany

Kiel Institute for the World Economy ( email )

Institute for the World Economy
Kiel, Schleswig-Hosltein
Germany

Inske Pirschel

Kiel Institute for the World Economy ( email )

P.O. Box 4309
Kiel, Schleswig-Hosltein D-24100
Germany

Dennis J. Snower (Contact Author)

University of Kiel - Institute for World Economics (IfW) ( email )

Duesternbrooker Weg 120
D-24118 Kiel
Germany
+49+431-8814-235 (Phone)

Institute for the Study of Labor (IZA)

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

Centre for Economic Policy Research (CEPR)

London
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

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