Optimal wage contracts under reference-dependent preferences

In this paper, we consider a labor market consisting of a firm and a worker and study employment contracts that the firm chooses when the worker has reference-dependent preferences with respect to wages. The firm offers an employment contract, which specifies the effort level and the wage in each pe-riod, and if the worker accepts the contract, she decides whether to continue working for the firm in each period. The worker forms a reference wage in each period based on the past wages, and we introduce gain–loss utility into the worker’s payoffs from employment and unemployment. We show, among other results, that when the initial reference wage is low, the firm’s optimal employment contract has initial high wages if the worker is loss averse and initial low wages if she is gain seeking. Our results provide explanations for signing bonuses and seniority-based pay systems based on reference-dependent prefer-ences.