The Role of Expectation in Job Search and Firm Size Effect on Wages

One of the most puzzling facts in economics is the firm size-wage effect. After controlling for the observable characteristics of workers (age, gender, education, residence etc.), firms (industry, occupation, work conditions etc.) and negotiation effect (unionization), one still finds that the sheer size of a firm increases the wage, contrary to the one-good one-price doctrine. We provide a simple dynamic game model of wage determination to give a new rationale to the firm size-wage effect. We think that the wages are not market clearing prices but strategies by firms. Firms choose wages to control workers search behavior. The essential feature of the model is that a large firms history of wages is observable to all the current and future workers, while a small firm is not visible and only its current offer is observable. Therefore a small firm is expected to be a myopic low-wage payer, and its workers will search for outside offers and quit often. A large firm can prevent search if it maintained a high wage throughout the past, by making workers expect high future wages. In this way, the firm size determines the worker expectations of its future wages, which changes the quit rate and equilibrium wages. To give additional support to our theoretical result, we test a new aspect of firm size-wage effect. Since the effect on wage levels are extensively studied, we derive two main hypotheses on wage gains after job changes. (H1) The proportion of firms that are larger than the previous employer increases the wage gain. (H2) The size of the previous employer decreases the wage gain. The firm size distribution effect (H1) is a new test. We obtain supports for both. Thus we conclude that the wages are strategies and affected by how workers utilize the firm size information in changing jobs. JEL classification number: C23, C73, D83, J30.