Great expectations: Reservation wages and minimum wage reform

"Minimum wage laws increase the reservation wages of low-wage workers, but only for a limited time."

Labor market models with search frictions predict that minimum wages may induce positive employment effects if they encourage more workers to join the labor force. A wage floor can increase the number of people whose reservation wage (the threshold at which a potential worker is willing to accept a job offer) falls below the available market wage. Such a supply-side reaction could increase the quality of employment matches and the probability of filling vacancies in low-wage sectors. Yet, this supply-side effect can only mitigate potential employment losses if reservation wages are static. If reservation wages instead react to minimum wages by adjusting upward, non-employed job seekers do not necessarily increase their search intensity and, thus, this supply channel for possible positive employment effects would prove muted at best.

Despite an extensive literature examining wage and employment effects of workers, to date, very little evidence exists on the impact of minimum wages on the reservation wages of non-employed job seekers. This gap exists due to a lack of information about individual acceptance thresholds. One prominent exception is Falk et al (2006), who conduct a lab-based experiment and find a positive and significant impact of minimum wages on reservation wages. To our knowledge, the present paper is the first study using quasi-experimental methods to empirically identify the causal effect of a minimum wage reform on reservation wages of non-employed job seekers in a real-world setting.

We rely on data from the German Socio-Economic Panel (SOEP), one of the few nationally representative surveys worldwide that ask non-employed respondents about their reservation wages. We employ a difference-in-differences strategy using variation in exposure to the reform across regions and time to pin down the causal effect of interest. In particular, we use the fact that the share of workers exposed to minimum wages differs across regions, which is why regional labor markets, where non-workers reside, are also differentially exposed to the reform. Thus, we compare reservation wages of individuals facing different levels of exposure before (2013-2014) and after the reform (2015-2017).

Our findings offer novel insights about the relationship between minimum wages and reservation wages. Firstly, wage acceptance thresholds increase only at the bottom of the reservation wage distribution, among workers likely to transition into jobs bound by the minimum wage. Specifically, acceptance thresholds rise by roughly 16 percent at the bottom 10th percentile, i.e. the bottom 10 percent of individuals in terms of hourly reservation wages in our sample, and between 9-15 percent at the 20th percentile of reservation wages during the first two years after the introduction. Higher percentiles do not exhibit any change in wage acceptance thresholds. Secondly, this increase does not persist indefinitely and, by the third year following implementation, becomes indistinguishable from zero. This behavior is suggestive of learning on the job market. Indeed, we can show that, after the introduction of the minimum wage, an increase in reservation wages in the lowest quartile of the distribution decreases the job finding probability for these job seekers.

This insight is based on the following article:

Fedorets, A., & Shupe, C. (2021). Great expectations: Reservation wages and minimum wage reform. Journal of Economic Behavior & Organization183, 397-419.

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