Question

This question will ask you about the sequential search theory of unemployment.

a) What is the reservation wage?

b) What does sequential search theory predict about its behavior over the unemployment spell?

c) In the data, reservation wages typically decline over the unemployment spell. Provide 3 possible reasons why this might be the case.

d) Are declining reservation wages consistent or inconsistent with negative duration dependence?

e) How might you reconcile the empirical regularities of (i) declining reservation wages and (ii) negative duration dependence?

Answer 1

(a). Reservation wage is the lowest amount for which a worker would be ready to take up a job. Factors influencing reservation wages are age, marital status, duration of unemployment, living conditions etc.

(b). According to the sequential search theory, there is a cost of indecisiveness. Search theory suggests choosing a suitable and economically viable option from the available set of opportunities as a delay would involve costs. Hence, unemployment for a long duration would mean that an individual would be ready to take up a job at a relatively lower wage as prolonging the duration of unemployment be costly.

(c). Three reasons why reservation wages decline over long unemployment spell:-

• Reduced skill levels.
• Risk aversion (i.e) if the worker is not ready to take the risk of waiting longer for a desirable job.
• Rising costs due to unemployment. (Something is better than nothing)

(d). Declining reservation wages are consistent with negative duration dependence as longer the duration of unemployment, lesser is the availability of jobs and hence it means reduced capacity to demand higher wages.

(e). The relationship between reservation wages and duration dependence is directly proportional. This means that longer one stays unemployed, the chances of securing a job decreases. This means the capacity to demand higher reservation wages declines the longer one stays unemployed. This is because unemployment results in loss of skills, increasing risk aversion, and rising costs. This reduces the bargaining capacity of the individual.