Journal of Economic Theory and Econometrics: Journal of the Korean Econometric Society

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Journal of Economic Theory and Econometrics
Journal of the Korean Econometric Society

Optimal Wage Contracts under Reference-Dependent Preferences

Vol.32, No.1, March , 54–79

  •   (The University of Texas at Austin)

  •   (Yonsei University)


In this paper, we consider a labor market consisting of a firm and a worker and study employment contracts that the firm chooses when the worker has reference-dependent preferences with respect to wages. The firm offers an employment contract, which specifies the effort level and the wage in each period, and if the worker accepts the contract, she decides whether to continue working for the firm in each period. The worker forms a reference wage in each period based on the past wages, and we introduce gain-loss utility into the worker's payoffs from employment and unemployment. We show, among other results, that when the initial reference wage is low, the firm's optimal employment contract has initial high wages if the worker is loss averse and initial low wages if she is gain seeking. Our results provide explanations for signing bonuses and seniority-based pay systems based on reference-dependent preferences.

   Reference Dependence, Wage Contracts, Gain-Loss Utility, Loss Aversion, Gain Seeking

JEL classification codes
   D91, J31, C61, M50

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