Reservation Wage
What is Reservation Wage?
A reservation wage is the lowest wage at which a person will accept a job, so any offer below it is turned down in favor of continued search.
A job seeker weighs the value of accepting an offer now against the value of waiting for a better one plus whatever time outside work is worth to them, and the wage that makes those equal is the reservation wage. It rises with better outside options: unemployment benefits, savings, another earner in the household, or the expectation that stronger offers are out there. It falls as savings run down and benefits expire, which is why acceptance rates climb and accepted wages slip late in a long unemployment spell. Reservation wages also explain why the labor supply curve slopes up, since a higher market wage clears the threshold of people who would otherwise stay home. Do not confuse it with the minimum wage, which is a legal floor on what employers may offer rather than a personal threshold.
Reservation Wage: a worked example
An unemployed worker collects $400 a week in benefits and values a week at home at $100, so an offer has to beat $500 a week to be worth taking. He turns down $480 and accepts $560. When his benefits run out, only the $100 value of time at home is left, so his reservation wage drops to $100 and the same $480 offer now looks good. Nothing about the job changed, only his outside option. This is the mechanism behind the finding that longer benefit durations stretch out unemployment spells and that wages accepted late in a spell tend to be lower.
The mistake students make with reservation wage
Students confuse the reservation wage with the minimum wage. One is a personal threshold that differs across people and shifts with circumstances, while the other is a legal floor binding on every covered employer. A second mistake is reading a high reservation wage as laziness. Holding out for a better match is an investment that can raise the eventual wage and how long the job lasts, even though it also lengthens the spell of unemployment.
Reservation Wage questions
What is the difference between the reservation wage and the minimum wage?
The reservation wage is the lowest pay an individual will voluntarily accept, while the minimum wage is the lowest pay an employer is legally allowed to offer. One varies from person to person and week to week, and the other is set by law for everyone covered. A person's reservation wage can sit above or below the legal minimum.
What makes a person's reservation wage rise?
A reservation wage rises when the alternatives to taking a job improve: unemployment benefits, savings, income from another household member, a strong labor market that promises better offers, or a high value placed on time at home. Skills and experience raise it too, because a well qualified worker expects better offers. It falls when those supports weaken.
Do unemployment benefits raise the reservation wage?
Yes, more generous or longer lasting unemployment benefits raise the reservation wage, because turning down an offer costs less. The usual finding is that this lengthens the average unemployment spell somewhat. Economists disagree about the size of the effect and point to an offsetting gain, since more search time can produce a better job match.
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