Habit formation and wage determination

Laszlo Goerke

doi:10.1002/mde.3213

Abstract

We analyse the implications of habit formation relating to wages in a multiperiod efficiency‐wage model. If employees have such preferences, their existence provides firms with incentives to raise wages and reduce employment over time. Greater intensity does not necessarily have the same consequences, because wage adjustments counteract the initial level impact. The firm's response additionally depends on the wage dependency of dismissal costs, because such costs make an increasing wage profile over time more attractive and mitigate the effects of greater intensity of habit formation. We further show that short‐lived productivity shocks have long‐lasting wage and employment consequences. Moreover, habit concerns by firm owners reduce wages.

Highlights

We consider a multiperiod efficiency-wage setting in which employees exhibit habit concerns about wages. Such preferences imply that current wage income, ceteris paribus, reduces future effort
We show that the existence of habit concerns induces the firm to raise wages from one period to the as long as dismissal costs are sufficiently low
Our first important insight is that greater intensity of habit concerns is more likely to have the same effects as the existence of such preferences, that is, to result in an increasing wage profile, the greater the wage dependency of dismissal costs is

Summary

Introduction

The theoretical analysis predicts increasing wage profiles over time if the workforce exhibits habit formation and dismissal costs are zero (Proposition 1), whereas constant wages maximise profits in the absence of such concerns. If habit concerns by employees and wage-dependent dismissal costs have the same strength or if they are absent (β = s0 ≥ 0), a positive productivity or price shock in period 1 raises contemporaneous employment and has no impact on wages, effort and period 2 employment.

Results

Conclusion