Reference Dependence and Labor-Market Fluctuations∗

We incorporate reference-dependent worker behavior into a search-matching model of the labor market, in which firms have all the bargaining power and productivity follows a log-linear AR(1) process. Motivated by Akerlof (1982) and Bewley (1999), we assume that existing workers’ output falls stochastically from its normal level when their wage falls below a "reference point", which (following Kőszegi and Rabin (2006)) is equal to their lagged-expected wage. We formulate the model game-theoretically and show that it has a unique subgame perfect equilibrium that exhibits the following properties: existing workers experience downward wage rigidity, as well as destruction of output following negative shocks due to layoffs or loss of morale; newly hired workers earn relatively flexible wages, but not as much as in the benchmark without reference dependence; market tightness is more volatile than under this benchmark. We relate these findings to the debate over the “Shimer puzzle” (Shimer (2005)). ∗Spiegler acknowledges financial support from the European Research Council, Grant no. 230251. We thank Gadi Bar-Levy, Martin Dufwenberg, Erik Eyster, Elhanan Helpman, Christopher Pissarides, Thijs van Rens, Ariel Rubinstein, Ron Siegel, Balazs Szentes, Eran Yashiv, Michael Woodford, Alwyn Young and numerous seminar participants for helpful comments. †Brown University. E-mail: [email protected]. ‡Tel Aviv University and University College London. URL: http://www.tau.ac.il/~rani. E-mail: [email protected].