Insights from Behavioral Economics on How Labor Markets Work

I discuss some key issues raised by behavioral economics for better understanding the working of the labor market. Amongst the key points in this paper are: (i) a revised modeling of the labor supply curve, with a specific focus on the target income approach (ii) elaborating on the importance of effort variability for understanding labor supply, including a narrative on efficiency wage and x-efficiency theory (includes the importance of fairness) (iii) building upon x-efficiency and efficiency wage theory to better understand the demand side of the labor market (iv) discussing some of the cognitive/informational/institutional factors affecting decision-making, including modeling the role of errors or biases in labor market decisions for both the supply and demand side of the labor market (v) insights of experimental economics for labor market behavior (vi) the importance behavioral economics for better understanding the stylizing facts of labor markets. This paper also compares conventional to behavioral theoretical approaches labor markets, their different underlying assumptions, and analytical predictions, with implications for public policy and institutional design. Also compared are the errors and biases and the bounded rationality approaches labor market analysis. They produce different analytical predictions as well as having different implications for public policy and institutional design