It is well documented that employers refuse to hire workers who offer their
services at less than the prevailing wage. The received explanation is tha
t workers are motivated by reciprocity - they desire to reward kindness and
punish hostility. To refuse an outsider's underbid is viewed as a kind cho
ice 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, equili
brium behaviour accords well with the aforementioned stylized facts. (C) 20
00 Elsevier Science B,V. All rights reserved. JEL classification: D63; E24;
J41.