Reservation Wage

The reservation wage is the minimum wage required by a worker to participate in the labor force willingly. It is an essential tool used by economists, in conjunction with micro and macroeconomic factors, to understand labor supply in a particular industry and various job search models.

Its significance lies in its ability to provide insights into the labor market and help policymakers design effective policies to improve labor force participation. It also reflects the worker's opportunity cost of not working. It is influenced by factors such as expected market salaries and future wages. As workers search for jobs, they become more selective and raise their minimum acceptable wages.

• The reservation wage is the minimum wage rate that a worker is willing to accept in exchange for their labor, such that they are indifferent between working and not working.
• It is influenced by various factors, including the worker's non-labor income, taxes, job characteristics, personal preferences, and market conditions.
• It can be calculated using a formula that considers the worker's utility function, which represents their preferences for consumption and leisure, and their budget constraint, which reflects their income and tax liabilities.

Reservation wage is a concept defined by the reservation wage theory as the marginal leisure utility divided by the dollar marginal utility of consumption. This theory suggests that the acceptable minimum wage is validated when workers spend all their working hours as leisure, and only their non-labor income is used to meet their consumption needs. As a result, the acceptable minimum wage declines somewhat slowly for unemployed people.

In economics, the reservation wage rate concept refers to a person's capability, readiness, and inclination to accept or reject any job offer from an employer. Several factors affect the reservation wage, including:

• Unemployment insurance: The more generous the unemployment insurance, the higher the minimum acceptable wage.
• Income of spouses: If a spouse's income can sustain the worker for longer, then the minimum acceptable wage would be higher for the person.
• Government welfare benefits: Many governments, such as the US, provide unemployment benefits to their citizens, leading to higher and more rigid minimum acceptable wage for unemployed individuals.
• Non-labor income: If a person receives non-labor income, such as social security benefits, their minimum acceptable wage would be higher.
• Cost of movement plus other costs: If the cost of movement for workers increases, the worker tries to match their acceptable minimum wage with the cost incurred, increasing the acceptable minimum wage.

Assuming a worker's utility function depends on their consumption C and labor L, we can represent it as follows:

u(C, L) = log(C) – θL (1)

Where the worker has the option to choose between working (L=1) or not working (L=0), and Θ > 0 represents the worker's preference for work.

Workers face a budget constraint that includes their labor income (wL), non-labor income (A), and taxes. For simplicity, we consider two types of taxes: lump-sum taxes (T) and single labor income taxes (t). The budget constraint can be represented as:

C = (1 − t)wL + A − T (2)

To derive the reservation wage formula, we use equation (2) to express it in terms of labor (L) only:

u(L) = log – θL

If the worker decides to work (L = 1), their related utility is:

u(1) = log – θ

If the worker decides not to work (L = 0), their related utility is:

u(0) = log(A − T) – θ

Therefore, the worker will work only if u(1) > u(0), or when log − θ > log(A − T), which simplifies to:

log − θ = log(A − T)

For the worker, the minimum acceptable wage is the wage that makes them indifferent to working or not. We assume there is a certain wage value, W, that achieves this indifference. Solving for W, we get:

W = / (1 − t) (3)

This formula shows that the reservation wage depends on non-labor income (A), taxes (T and t), and the worker's preference for work (θ).

Let's say an individual has a non-labor income (A) of $50,000, faces a lump-sum tax (T) of $10,000, and a single labor income tax rate (t) of 20%. The individual has a preference for work (θ) of 0.5.

Using the formula for the reservation wage:

W = / (1 − t)

= / (1 - 0.20)

= / (0.80)

W = $82,434.375

Therefore, the reservation wage for this individual is $82,434.375. This means the individual would only accept a job offer if the wage is at least $82,434.375.

This has been a guide to what is Reservation Wage. Here, we explain it in detail with reservation wage formula and calculation example. You can learn more about it from the following articles -

• Wage-Price Spiral
• Superannuation
• Efficiency Wages