Why firms refuse to hire underbidders

A prominent theory of wage rigidity claims that a social norm against underbidding may prevent wages from falling to market clearing levels. This social norm may therefore cause downwardly rigid wages and involuntary unemployment. Recently performed questionnaire studies have thrown doubt on the conjecture that there is a social norm against underbidding. In this paper we experimentally show that the impact of underbidding may crucually depend on the nature of the labour contract. If labour contracts are incomplete wages may not approach the market clearing level even in the presence of severe underbidding. __________________________________________________________________________________________ We gratefully acknowledge financial support from the Swiss National Science Foundation (No. 12-43590.95). We would like to thank the conference participants of the GAPE Meeting in Maastricht for their helpful comments.