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Goette, Lorenz
Huffman, David
Year of Publication: 
Series/Report no.: 
IZA Discussion Papers 1895
Traditionally, models of economic decision-making assume that individuals are rational and emotionless. This chapter argues that the neglect of emotion in economic models explains their inability to predict important aspects of the labor market. We focus on one example: the scarcity of nominal wage cuts. Firms frequently cut real wages of workers, by increasing nominal wages by less than the inflation rate, but seldom cut nominal wages, in contrast to the predictions of the standard, rational model. This pattern suggests that workers exhibit a special resistance to nominal wage cuts, which is hard to explain if they are purely rational. We argue that strong resistance to nominal wage cuts is best understood in terms of a model where, consistent with evidence from psychology and neuroscience, salient features of a situation trigger emotional responses and sway judgment of the entire situation. Since a cut in the wage is a very salient feature, we argue that cutting the nominal wage leads to a reaction that is mainly dominated by emotions. On the other hand, we hypothesize that an increase in the nominal wage produces a more deliberative evaluation, because there is no immediately salient feature: the individual needs to compare the inflation rate to the wage change before it becomes clear whether the change increases or decreases utility, thus producing a more measured response. We present evidence from experiments that supports this argument: self-reported emotions such as anger and surprise respond strongly to nominal wage cuts, but not to decreases in the real wage achieved through increasing the nominal wage by less than the inflation rate. Although emotions may benefit individual workers, by strengthening their bargaining position and preventing wage cuts, we argue that overall impact on labor market outcomes is ambiguous, because a survey of the evidence suggests that higher wages tend to lead to higher unemployment.
wage rigidity
money illusion
loss aversion
Document Type: 
Working Paper

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