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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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Falk et al. (2006) also find that the economic consequences of a removal of the minimum wage are very asymmetric relative to the effects of the introduction. While subjects’ reservation wages decrease somewhat after the removal of the minimum wage, they still substantially exceed those before its introduction. It seems that the minimum wage leads to a kind of ratchet effect in subjects' perceptions of what constitutes a fair wage. Subjects who are used to receiving high wages seem to feel morally entitled to receive them even after the abolishment of the minimum wage legislation. The forces behind the stickiness of reservation wages, which are similar to the forces discussed in the context of downward rigidity of wages, also induce an asymmetry in the response of actual wages: the absolute change in wages after the introduction of the minimum wage is much larger than after its elimination, implying that minimum wage laws carry important hysteresis effects. Actual wages after the elimination of a minimum wage increase will tend to be higher than before the introduction of a minimum wage increase. The asymmetric effect of the minimum wage on reservation wages may explain why firms may find the utilization of subminimum wage opportunities unprofitable, because these opportunities were typically introduced after a previous increase in the minimum wage.

Of course, the laboratory experiment described above represents only the first step in a long lasting research endeavor. One experiment alone will never be conclusive – be it a lab or a field experiment. However, the results suggest interesting hypotheses and a high payoff for efforts directed at the collection of hitherto unavailable data, such as reservations wages.

Moreover, as the literature on the gift exchange shows, effects that have been found in the laboratory may generalize to field settings outside the laboratory, and much is at stake in the current case. If the asymmetric impact of minimum wage laws on reservation wages turns out to be a robust finding, it will have profound consequences. First, it questions the basic assumption that the minimum wage does not affect labor supply. Second, the upwards shift in the labor supply curve that increases in the minimum wage generate introduces a further employment limiting aspect of minimum wage increases. Third, the asymmetric impact on reservation wages and actual wages challenges the standard assumption in economics that the size of a comparative static result does not depend on the sign of the change in the independent variable. If economic policies generate entitlement effects that respond asymmetrically to the introduction and the removal of the policy, much of what is taught in economic textbooks needs to be rewritten because the introduction of a policy may have effects that prevail even after it has been abolished.17 In the labor market context, this means that reductions in minimum wages are likely to cause much smaller employment effects than one would expect from standard competitive or monopsonistic models.

5 Conclusions Many employment relations are only incompletely regulated by explicit contracts, giving employees discretion over their effort choices. In addition, these relations are embedded in a context of repeated interactions between employers and employees. We also know from a large experimental literature – which provides evidence from many different countries, from studies involving high stakes, and from nationally representative experiments – that a substantial share of the people exhibits (reference-dependent) social preferences and concerns for fair outcomes. In this paper we combine these insights and argue that they can help us provide a better understanding of phenomena such as downwards nominal wage rigidity, the unresponsiveness of incumbents’ wages to labor market conditions, cohort effects or nonAsymmetric responses to the introduction and elimination of policy measures are of course not restricted to minimum wage legislation. Card and Hyslop (2006) show, for example, that a dynamic earnings subsidy increased participation of welfare recipients in the labor market even after the subsidy expired.

competitive wage premia. Such phenomena are hard to reconcile with the competitive model, but they follow in a relatively straightforward manner from a labor market account that acknowledges (i) the inherent incompleteness and relational nature of most employment contracts and (ii) the existence of reference-dependent fairness concerns that are shaped by nominal loss aversion. Direct evidence from laboratory and field experiments is supportive of our account which is also strengthened by the insight that even a small share of fair-minded workers can have a large impact on long-term employment relations because reputational concerns in repeated interactions greatly magnify the impact of fairness concerns.

The evidence we survey also has several implications for policy and raises new questions.

First, downward nominal wage rigidity may create a permanent tradeoff between inflation and unemployment: In an economy with heterogeneous productivity changes the productivity of some jobs rises while some jobs become less productive. In the more productive jobs real wages will rise while in jobs with a productivity decrease real wages should fall. However, at low levels of inflation a real wage cut can only be achieved by cutting nominal wages. Thus, if downwards nominal wage rigidity prevails the aggregate real wage rises permanently because firms are reluctant to cut nominal wages. This reluctance acts like a productivity decrease in the economy and consequently depresses employment and output (Akerlof et al 1996). Second, the theory and evidence on internal labor markets more generally suggest that any temporary intervention can have effects that are much more long-lasting than the standard model suggests. The reason is that any temporary shock that affects entry-level wages matters for future wages because of their impact on the reference standards (see Fehr et al (2008) for a more detailed discussion).





Our results also raise several issues that future research needs to address. First, there is still little evidence on how fairness and relational contracting interact in the field. While it may not be feasible to finance a long-term experiment, it may be possible to tap into an existing environment and examine how a change in pay affects effort compared to a case in which there is essentially no future relationship. In this context it is also worthwhile to stress that from the perspective of our fairness account only those wage variations that are associated with perceived fairness variations will tend to change the workers' behavior (Cohn et al 2007).

Thus, the psychological context in which wage variations take place needs to be taken into account to avoid the naive view that every wage increase leads to an effort increase. For example, if workers receive a surprise wage increase without any explanation, it is hard to see why they should view this as a fairness variation. This also means that researchers must not only collect data on wages and effort, but also important related information such as fairness judgments, workers’ beliefs about the employers’ intentions, or the rationale that employers give to the workers for why they increase wages, whether employers expect higher effort in return (and whether workers believe this), and the like.

Second, it is worth recalling that the theory and evidence we discussed here is related to issues of vertical fairness. This may suffice in some cases, i.e., when a firm only hires identical workers. As our discussion shows, vertical fairness concerns may lead firms to pay more generous wages, leading to particular wage dynamics. As such, this framework could also provide testable hypotheses which firms pay high wages, possibly explaining inter-industry wage differentials (Krueger & Summers 1988). Our framework predicts that more profitable firms should pay more to all workers.18 However, issues of fairness between workers may become important in other cases (Livernash 1957). Several recent papers provide laboratory evidence on the role of horizontal social comparisons for workers’ effort choices in a gift exchange environment (Charness & Kuhn 2007; Clark et al 2006; Gächter & Thöni 2005).

Neuroimaging experiments also provide evidence for the importance of social comparisons (Fliessbach et al 2007) and there is also convincing field evidence that workers influence each other in choosing how hard to work (Mas & Moretti 2008). A plausible interpretation of these results is based on horizontal fairness concerns, raising the possibility that such concerns are more generally important. They may constrain firms even more in their policies and may have even more sweeping implications than those discussed here. For instance, as pointed out in Our best interpretation of the long and ongoing controversy regarding the respective role of individual and firm heterogeneity contributing to the industry wage differentials is that a substantial part is due to genuine differences in firms’ wage policies (Abowd, Finer and Kramarz, 1999).

recent work (Cabrales et al 2008), if workers strongly care about relative wages, this creates an incentive for firms to segregate workers of different skill levels, and also has implications for wage policies. No evidence exists on even the most basic implications from horizontal fairness concerns, and this is clearly an important area for future research.

Abowd J, Finer H, Kramarz F. 1999. Individual and Firm Heterogeneity in Compensation: An Analysis of Matched Longitudinal Employer and Employee Data for the State of Washington. In The Creation and Analysis of Employer-Employee Matched Data, ed. J Haltiwanger, J Lane, J Spletzer, K Troske, pp. 3-24: North Holland Agell J, Lundborg P. 1995. Theories of Pay and Unemployment: Survey Evidence from Swedish Manufacturing Firms. Scandinavian Journal of Economics 97:295-307 Agell J, Lundborg P. 2003. Survey Evidence on Wage Rigidity and Unemployment.

Scandinavian Journal of Economics 105:15-30 Akerlof GA. 1982. Labor Contracts as Partial Gift Exchange. The Quarterly Journal of Economics 97:543-69 Akerlof GA, Dickens WT, Perry GL. 1996. The Macroeconomics of Low Inflation. Brookings Papers on Economic Activity 1996:1-76 Akerlof GA, Yellen JL. 1990. The Fair Wage-Effort Hypothesis and Unemployment. The Quarterly Journal of Economics 105:255-83

Al-Ubaydli O, Andersen S, Gneezy U, List JA. 2006. For Love or Money? Testing NonPrecuniary and Pecuniary Incentive Schemes in a Field Experiment. Working paper:

University of Chicago Altonji JG, Devereux PJ. 2000. The Extent and Consequences of Downward Nominal Wage Rigidity. Research in Labor Economics 19:383-431 Baker G, Gibbs M, Holmstrom B. 1994. The Wage Policy of a Firm. The Quarterly Journal of Economics 109:921-55 Baker GP. 1992. Incentive Contracts and Performance Measurement. The Journal of Political Economy 100:598-614 Barth E, Dale-Olsen H. 1999. Monopsonistic Discrimination and the Gender-Wage Gap.

NBER Working Paper No. 7197 Beaudry P, DiNardo J. 1991. The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data. Journal of Political Economy 99:665-88 Bellemare C, Kröger S. 2007. On Representative Social Capital. European Economic Review 51:181-202 Bellemare C, Kröger S, van Soest A. 2008. Measuring Inequity Aversion in a Heterogeneous Population using Experimental Decisions and Subjective Probabilities. Econometrica 76:815-39 Bellemare C, Shearer B. 2007. Gift Exchange within a Firm: Evidence from a Field Experiment. Working Paper Benjamin D. 2005. A Theory of Fairness in the Labor Market. Harvard University, Cambridge Berg J, Dickhaut JW, McCabe KA. 1995. Trust, Reciprocity, and Social History. Games and Economic Behavior 10 1:122-42 Bewley TE. 1999. Why Wages Don't Fall During a Recession. Cambridge: Harvard University Press Bewley TF. 1995. A Depressed Labor Market as Explained by Participants. American Economic Review 85:250-54 Binmore K, Gale J, Samuelson L. 1995. Learning to be imperfect: The ultimatum game.

Games and Economic Behavior 8:56-90 Boal WM, Ransom MR. 1997. Monopsony in the Labor Market. Journal of Economic Literature 35:86-112 Bolton GE, Ockenfels A. 2000. ERC: A Theory of Equity, Reciprocity, and Competition.

American Economic Review 90:166-93 Bound J, Brown C, Duncan GJ, Rodgers WL. 1994. Evidence on the Validity of CrossSectional and Longitudinal Labor Market Data. Journal of Labor Economics 12:345Brandts J, Charness G. 2004. Do Labour Market Conditions Affect Gift Exchange? Some Experimental Evidence. Economic Journal 114:684-708 Brown M, Falk A, Fehr E. 2004. Relational Contracts and the Nature of Market Interactions.

Econometrica 72:747-80 Brown M, Falk A, Fehr E. 2008. Competition and Relational Contracts: The Role of Unemployment as a Disciplinary Device. IZA Discussion Paper 3345 Brown M, Zehnder C. 2007. Credit Reporting, Relationship Banking, and Loan Repayment.

Journal of Money, Credit, and Banking 39:1883-918 Cabrales A, Calvo-Armengol A, Pavoni N. 2008. Social Preferences, Skill Segregation, and Wage Dynamics. Review of Economic Studies 75:65 - 98 Camerer C. 2003. Behavioral Game Theory: Princeton University Press Cameron LA. 1999. Raising the Stakes in the Ultimatum Game: Experimental Evidence from Indonesia. Economic Inquiry 37:47-59 Card D. 1992. Do Minimum Wages Reduce Employment? A Case Study of California, 1987Industrial and Labor Relations Review 46:38-54 Card D, Hyslop D. 1996. Does Inflation "Grease the Wheels of the Labor Market"? NBER Working Papers, National Bureau of Economic Research Card D, Hyslop DR. 2006. The Dynamic Effects of an Earnings Subsidy for Long-Term Welfare Recipients: Evidence from the SSP Applicant Experiment. National Bureau of Economic Research Working Paper 12774 Card D, Krueger A. 1994. Minimum Wages and Employment: A Case Study of the Fast-Food Industry in New Jersey and Pennsylvania. The American Economic Review 84:772-93 Card D, Krueger A. 1995. Myth and Measurement: The New Economics of the Minimum Wage: Princeton University Press Carmichael HL, MacLeod WB. 2000. Worker Cooperation and the Ratchet Effect. Journal of Labor Economics 18:1-19 Charness G. 2004. Attribution and Reciprocity in an Experimental Labor Market. Journal of Labor Economics 22:665-88 Charness G, Frechette GR, Kagel JH. 2004. How Robust is Laboratory Gift Exchange?

Experimental Economics 7:189-205 Charness G, Kuhn P. 2007. Does pay inequality affect worker effort? Experimental evidence.



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