September 2000

IZA DP No. 196: Equilibrium Wage Arrears: A Theoretical and Empirical Analysis of Institutional Lock-In

revised version published as' Complementarity and Custom in Wage Contract Violation' in: Review of Economicss and Statistics, 2009, 91 (4), 832 - 849

We present a model of wage contract violation that implies a possibility of multiple equilibria in the level of arrears. Positive feedback arises because each employer’s arrears affect the costs of late payment faced by other employers operating in the same labor market, resulting in a network externality or strategic complementarity in the adoption of the practice. We study the case of three equilibria, distinguishing two that are stable: the "punctual payment equilibrium" and the "late payment equilibrium." Our econometric analysis of linked employer-employee data for Russia supports the model’s contention that the firm’s costs of wage arrears - as embodied in worker effort, quit and strike behavior, and the probability of legal penalties - are attenuated by arrears in the local labor market. We estimate the arrears reaction function implied by the model, showing that it exhibits strongly positive feedback, and that the theoretical conditions for multiple equilibria under symmetric local labor market competition are satisfied in 1995 and 1998. Simulation results imply a late payment equilibrium characterized by six monthly overdue wages for a typical worker in 1995 and nine in 1998.