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«IZA DP No. 3901 A Behavioral Account of the Labor Market: The Role of Fairness Concerns Ernst Fehr Lorenz Goette Christian Zehnder December 2008 ...»

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IZA DP No. 3901

A Behavioral Account of the Labor Market:

The Role of Fairness Concerns

Ernst Fehr

Lorenz Goette

Christian Zehnder

December 2008


zur Zukunft der Arbeit

Institute for the Study

of Labor

A Behavioral Account of the Labor Market:

The Role of Fairness Concerns

Ernst Fehr

University of Zurich

and IZA

Lorenz Goette

Federal Reserve Bank of Boston and IZA Christian Zehnder University of Lausanne Discussion Paper No. 3901 December 2008 IZA P.O. Box 7240 53072 Bonn Germany Phone: +49-228-3894-0 Fax: +49-228-3894-180 E-mail: iza@iza.org Any opinions expressed here are those of the author(s) and not those of IZA. Research published in this series may include views on policy, but the institute itself takes no institutional policy positions.

The Institute for the Study of Labor (IZA) in Bonn is a local and virtual international research center and a place of communication between science, politics and business. IZA is an independent nonprofit organization supported by Deutsche Post World Net. The center is associated with the University of Bonn and offers a stimulating research environment through its international network, workshops and conferences, data service, project support, research visits and doctoral program. IZA engages in (i) original and internationally competitive research in all fields of labor economics, (ii) development of policy concepts, and (iii) dissemination of research results and concepts to the interested public.

IZA Discussion Papers often represent preliminary work and are circulated to encourage discussion.

Citation of such a paper should account for its provisional character. A revised version may be available directly from the author.

IZA Discussion Paper No. 3901 December 2008

–  –  –

In this paper, we argue that important labor market phenomena can be better understood if one takes (i) the inherent incompleteness and relational nature of most employment contracts and (ii) the existence of reference-dependent fairness concerns among a substantial share of the population into account. Theory shows and experiments confirm, that even if fairness concerns were only to exert weak effects in one-shot interactions, repeated interactions greatly magnify the relevance of such concerns on economic outcomes. We also review evidence from laboratory and field experiments examining the role of wages and fairness on effort, derive predictions from our approach for entry-level wages and incumbent workers’ wages, confront these predictions with the evidence, and show that reference-dependent fairness concerns may have important consequences for the effects of economic policies such as minimum wage laws.

JEL Classification: C7, D00, D2, D8, J2, L2 Keywords: fairness, contracts, wages, effort, experiments

Corresponding author:

Ernst Fehr Institute for Empirical Research in Economics University of Zurich Blümlisalpstrasse 10 CH-8006 Zürich Switzerland E-mail: efehr@iew.uzh.ch * We are very grateful to valuable comments received from Daron Acemoglu, Charles Bellemare, Andrew Clark, Thomas Dohmen, Rafael Lalive, Bentley MacLeod, James Malcomson and Rudolf Winter-Ebmer.

1 Introduction In this paper, we argue that the institutional and psychological assumptions inherent in the standard competitive model of the labor market often lead to a distorted view of the workings of labor markets. Several facts about labor markets are at odds with the competitive model.

For instance, the standard model has a hard time explaining why labor market conditions have little effect on incumbent workers’ wages, why nominal wages are downwardly rigid, and why labor market conditions upon entering a firm can have long-lasting effects on workers’ pay. Although these facts have important consequences for labor market outcomes, the competitive view of the labor market remains surprisingly persistent and continues to play a dominant role. The standard model in economics also assumes that all actors have preferences defined solely over the level of their own consumption; experimental research, however, has shown this assumption to be problematic in many circumstances. Many individuals are willing to sacrifice some of their own consumption to restore fairness. Furthermore, utility, and in particular, the effects of fairness perceptions on utility, are typically referencedependent, as we discuss in the next section.

The standard model of the competitive labor market relies on the assumption of well-specified and complete employment contracts, while real-life employment relationships are often characterized by incomplete contracts in which many dimensions of the interaction between employer and worker are left unspecified. In particular, effort is typically not contractible, meaning that the generation of a sufficiently motivated work force is key for a firm's productivity. As a first reaction, one might think that this should imply that pay for performance is wide-spread. However, as we will discuss in more detail later on, the effective usage of explicit incentives are limited to a narrow set of occupations. Evidence shows that apart from the upper levels of the firm's management, only few employees face explicit performance incentives and fixed hourly wages and monthly salaries are very common. In a static model, this implies that the only motivator firms use is to treat workers well and to count on their preference for fairness to reciprocate the favor. This is in line with the well documented empirical fact that managers often stress that "workers have many opportunities to take advantage of employers so that it is not wise to depend on coercion and financial incentives alone as motivators. [...] Employers believe that other motivators are necessary, which are best thought of as having to do with generosity" (Bewley 1995).

However, many people doubt that relying on a taste for fairness in workers is enough to overcome the motivational problem incomplete employment contracts pose. We review evidence from many laboratory and field experiments indicating that this doubt is justified.

While most studies confirm that many subjects are willing to work harder if they are paid a generous wage rent, the results also show that this effect is limited in one-shot interactions and that a substantial share of the subjects provides little effort in this case. As a consequence, the positive impact of fairness concerns on performance in one-shot employment situations still leaves effort far below the efficient level.

This brings us to a second important feature of labor markets, which the competitive model also neglects: employment relationships are hardly ever spot market transactions where trading partners interact only once. Rather, employers and workers have the option of interacting repeatedly with each other. The fact that many employment relationships are characterized by long-term relations greatly amplifies the importance of fairness preferences.

Game theoretic models of reputation formation show that strictly selfish individuals have an incentive to mimic fair-minded persons in a repeated setting and to exert high effort when offered a non-competitive wage rent, because this guarantees more rents in the future.

Shirking, in contrast, reveals that the individual is egoistic. Firms are unwilling to pay wage rents to selfish workers once they have proven they don't reciprocate generous treatment with high effort. In fact, even the presence of a small share of fair-minded workers in a dynamic environment with repeated interactions can have a large positive impact on performance. This reputation based mechanism can be tested explicitly in laboratory experiments and proves to be very powerful: if subjects in the role of employers and employees are allowed to enter finitely repeated interactions, a large effort increase occurs, but market interactions deviate systematically from competitive predictions.

The existence of fair-minded workers can also explain another frequently observed phenomenon in the labor market which is hard to reconcile with the competitive model.

Ample evidence indicates that there is a sharp difference between wage dynamics in internal and external labor markets: while entry-level wages respond strongly to shocks in aggregated labor market conditions, incumbent workers’ wages are much less responsive to changes in the outside environment. This is in line with survey evidence showing that there is a shift in what workers feel entitled to as they enter a firm. Workers who are looking for a job in a new firm seem to evaluate the fairness of a firm's wage offer relative to the going wage in the labor market. Incumbent workers, in contrast, seem to assess the fairness of proposed wage changes in their ongoing employment relative to the status quo. Accordingly, new and incumbent workers may react completely differently to the same wage offer from the firm, and while the firm may adjust the new entrants’ wages to labor market conditions, it has a good reason for holding those of the incumbents constant.

Finally, the prevalence of fair-minded workers in the labor market may also have important new implications for policy. The reason is that policy measures may influence the reference point relative to which workers evaluate the fairness of their employment situation. We illustrate this possibility with one of the most wide-spread instruments of labor market interventions: minimum wage legislation. We discuss experimental evidence which shows that changes in the level of the minimum wage strongly affect what subjects perceive as the fair wage. In particular, a rise in minimum wages also raises reservation wages, implying that the effect of minimum wages on wages and employment may be very different from that which standard labor market theories predict. Furthermore, since the effects of increases and decreases in minimum wages turn out to be asymmetric, minimum wage policy may have effects that prevail even after the policy has been reverted.

We are, of course, not the first to point out the importance of fairness concerns in employment relations and labor markets. Marshall (1925; 1969) and Hicks (1932) already argued for the relevance of fairness concerns in wage negotiations. Likewise, authors such as Slichter (1920), Akerlof (1982) and Rees (1993) stressed such concerns. We believe, however, that the more recent work benefits from the development of game theoretic tools and experimental methods which enable us to sharpen and deepen our understanding of fairness concerns in employment settings. Without game theoretic tools it is, for example, impossible to rigorously prove the theoretical claim that even if only a minority of subjects cares for fairness, fairness concerns may nevertheless strongly shape the overall outcome. Likewise, it is hard, if not impossible, to provide rigorous evidence for such a claim without using laboratory experimental tools. Moreover, the recent wave of field experiments enabled researchers to study the potential impact of fairness concerns in natural environments. We thus hope that – given these new techniques and opportunities – others will be encouraged to extend and deepen our knowledge of the role of fairness concerns in labor markets.

In the next section we will briefly describe the empirical basis of our main motivational assumptions, i.e. reference-dependent fairness preferences. In section 3, we substantiate our claim that many labor markets deviate fundamentally from the competitive model because of the inherent incompleteness and relational nature of the employment contract. We then review in section 4 the evidence of laboratory and field experiments that examine the impact of wage variations on effort. In this context, it is interesting to observe that laboratory and field evidence yield converging conclusions about the role of fairness preferences in one-shot or short-term interactions. We will also review evidence with a bearing on the role of fairness concerns in repeated interactions in this section, and will show that several important features of internal labor markets are consistent with the predictions of our approach. Finally, section 4 also discusses the claim that economic policies such as minimum wage laws may induce important shifts in the reference standards that form the basis for fairness judgments, thus causing potentially important effects on reservations wages, actual wages, and employment.

2 Psychological Forces

Standard economic analysis assumes that individuals’ preferences are defined only over their own economic payoffs, and that these payoffs enter the utility function in levels. However, evidence from two decades of research in experimental economics has questioned this assumption. We discuss two of the most intensively debated topics of this literature. The first concerns the assumption of selfishness, that is, that one's own consumption or economic payoff alone enters the utility function. The evidence indicates, however, that a significant share of individuals also cares about others' economic payoffs, and that the existence of heterogeneous social preferences has important behavioral effects. The second concerns the way in which economic payoffs enter the utility function. While the standard model assumes that only the level of payoffs matters, the evidence suggests that the levels are valued relative to a reference level. As we will discuss in the following sections, incorporating these two features of preferences leads to a new understanding of important labor market phenomena.

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