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Reservation wages and the wage flexibility puzzle

Authors: Felix Koenig, Alan Manning, Barbara Petrongolo

Date: June 2014

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 and matching model. This paper provides an alternative and informative perspective on the wage flexibility puzzle, which explains why the canonical model can only match the observed cyclicality of wages if the replacement ratio is implausibly high. We show that this failure remains even if wages are only occasionally renegotiated, unless the persistence in unemployment is implausibly low. We then provide some evidence that part of the problem comes from the implicit model for the determination of reservations wages. Estimates for the UK and Germany provide evidence that reservation wages are much less cyclical than predicted even conditional on the observed level of wage cyclicality. We present some evidence that elements of perceived “fairness” or “reference points” in reservation wages may address this model failure.

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