Reciprocity and wage undercutting

It is well documented that employers refuse to hire workers who offer their services at less than the prevailing wage. The received explanation is that workers are motivated by reciprocity - they desire to reward kindness and punish hostility. To refuse an outsider's underbid is viewed as a kind choice that is met with good effort; a low wage is viewed as an insult that is met with shirking. We have developed a general theory of reciprocity which in this paper is applied to a wage-setting game played by an employer and two workers. We show that when workers are motivated by reciprocity, equilibrium behaviour accords well with the aforementioned stylized facts. (C) 2000 Elsevier Science B,V. All rights reserved. JEL classification: D63; E24; J41.