8/2014 Liina Malk. Determinants of reservation wages: Empirical evidence for Estonia

Working Papers of Eesti Pank 8/2014

The probability of a job-seeker finding a job and thus the duration of unemploy­ment are determined by how probable it is that a job offer will be received and whether the job-seeker will accept the offer. Whether the offer will be accepted depends on the reservation wage, which is the lowest wage for which the unemployed person would be willing to go to work: they will accept the job offer if the wage offered is at least as high as the reservation wage.

The size of the reservation wage depends on other sources of income, the probability of a job offer being received, and the expected wage offer. The higher the alternative income is, for example from unemployment benefits or other household members, the higher the reservation wage is. The probability of a job offer being received depends on the general state of the labour market; the individual characteristics like age, education and qualifications of the unemployed person; and how intensive the search for a job is. The higher the probability that a job will be found and the higher the expected wage offer, the higher the reservation wage of the unemployed person. A higher reservation wage when all else is equal means that finding a job may be harder and the duration of unemployment may be longer.

The reservation wage may change during a period of unemployment, for various reasons. Firstly, the probability of a job offer being received and the expected wage being offered both depend on the general state of the labour market, and so changes in the labour market may have an effect on the wage expectations of the unemployed. Secondly, knowledge and skills may deteriorate the longer unemployment lasts, and employers may doubt the qualifications of the unemployed, and so the reservation wage can be expected to fall as the duration of unemployment lengthens. A longer duration of unemployment may, however, mean that the unemployed person gets to know the state of the labour market and wages better, and so can adjust their salary expectations accordingly. Thirdly, the reservation wage is affected by changes in alternative income, for example the expiration of unemployment benefits is expected to lower the reservation wage.

From this, a two-way relationship may be seen between the reservation wage of the unemployed and the duration of unemployment. Although a higher reservation wage will lengthen the search for a job, it may also be assumed that the lengthening of the job search will lead the unemployed to adjust their wage expectations. The aim of this paper is to assess whether this relation holds for the unemployed in Estonia and what other factors affect their wage expectations. The study is conducted using data from the Estonian Labour Force Survey 2011–2013.

The analysis shows that the reservation wage of the unemployed in Estonia decreases with age. It also reveals that the reservation wage of women is on average 24% lower than that of men. The reservation wage of men may be higher because men generally earn more, and so their wage expectations are also higher.

As expected, there is a positive relationship between education and the reservation wage, so that the higher the level of education, the higher the expected wage. The analysis indicates however that there is no statistically significant difference between the wage expectations of those with primary education and those of people with secondary education. It also becomes apparent that the effect of the level of education on the reservation wage is not significant for men or for unemployed people aged over 25.

From the analysis it appears that unemployed people who did not leave their previous job voluntarily, because they were fired or made redundant, have a much lower reservation wage. This is also to be expected, as those who have decided of their own free will to leave their job can probably permit themselves a period of unemployment, and their job search costs are smaller, meaning their wage expectations are higher. As lower job search costs may result from the household being economically better off, the positive relationship between household income and the reservation wage is also to be expected.

A negative relationship appears between the reservation wage and the regional unemployment rate, which indicates that the wage expectations of the unemployed looking for work in regions with higher unemployment are lower. The average wage in the region does not, however, have a significant effect on the reservation wage.

The effect of the duration of unemployment on the reservation wage appears to be negative. This means that longer unemployment spells lead to lower reservation wages. The results indicate that one extra month of unemployment leads to a fall of 0.5% in wage expectations. However, if the equation for the reservation wage is estimated separately by gender and by age group, it appears that this fall is mainly driven by men and older unemployed people.

JEL Codes: J31, J64

Keywords: unemployment, reservation wage, unemployment duration, instrumental variable regression

Authors e-mail address: liina.malk [at] eestipank.ee

The views expressed are those of the author and do not necessarily represent the official views of Eesti Pank.