Are wages habit-forming? evidence from micro data

Although utility functions play a central role in economics, the axiom that utility depends only on the absolute levels of its arguments is rarely tested. This paper uses panel data on 2000 British employees who remain with the same employer and who are not promoted! from one wave to the next. It is shown that one important measure of well-being, overall job satisfaction, is strongly positively correlated with the change in the worker's pay between waves, but is unrelated to the current level of pay. Empirical tests suggest that a reference-dependent satisfaction function, where individual well-being depends on current pay relative to past pay, is more consistent with these regression results than are productivity or agency explanations of increasing wage profiles. Some evidence is presented of greater job satisfaction effects of pay rises for Power paid, lass well-educated and younger workers. These results provide some micro evidence consistent with the theory, widespread in social science, of habituation: individuals may become used to any given; level of consumption or income. As such, they tie in with the finding that a country's well-being, as measured by the average happiness of its citizens, is only weakly correlated with its per capita GNP. (C) 1999 Elsevier Science B.V. All rights reserved.