Wage Formation: Towards Isolating Search and Bargaining Effects from the Marginal Product

This paper estimates the importance of workers’ outside options in wage determination. In models of search and bargaining, a worker’s wage is determined by the marginal product of labour and by a weighted average of wages in alternate jobs. Thus, the nature of the wage equation makes it difficult to isolate changes in workers’ outside options that are independent from changes in the marginal product of labour. This paper builds on the predictions of a search and bargaining model with multiple cities, industries and occupations to propose novel identification strategies. Using a unique administrative panel database for Germany, the study exploits differences in both the employment composition across cities and in job-specific skill transferability as sources of variation for identification. The main finding of the paper is that a 10% increase in the outside options of a worker generates a 7% wage increase.