The Behavioral Economics of the Labor Market: Central Findings and Their Policy Implications

Many labor markets are characterized by long-term employment relations and incomplete labor contracts. The employees’ effort, in particular, is typically not contractible so that effort needs to be enforced endogenously in repeated interactions. Theory and evidence shows that under these conditions fairness concerns play an important role in affecting effort choices and wage setting, rendering wage levels and wages’ responsiveness to shocks rather rigid. In addition, loss aversion and money illusion interact with fairness concerns to generate downwards nominal wage rigidity and in case of strong unions downwards real wage rigidity. Thus, key structural features of labor markets such and long-term relations and contractual incompleteness and the psychological forces of fairness concerns, loss aversion and money illusion lead to substantial departures from the predictions of the standard competitive model, rendering this model problematic for policy prescriptions. We illustrate this claim for two policy domains monetary policy and minimum wage legislation. ∗We thank Tyler Williams for excellent research assistance. The views expressed herein do not necessarily reflect those of the Federal Reserve Bank of Boston or the Federal Reserve System. †University of Zurich, Institute for Empirical Research in Economics. Email: [email protected] ‡Federal Reserve Bank of Boston, Center for Behavioral Economics and Decision Making. Email: [email protected] §Harvard Business School and Federal Reserve Bank of Boston, Center for Behavioral Economics and Decision Making. Email: [email protected]