Many economies exhibit downward wage rigidity. Surveys of managers by Bewley [1999] and Campbell and Kamlani [1997] indicate that employers hold wages rigid because they believe morale will su↵er after a wage cut. Otherwise, there is little evidence for how employers' beliefs about workers contribute to wage rigidity and whether those beliefs are accurate. We demonstrate that e↵ort falls after workers experience a wage cut and also that workers form reference points from wage contracts. Despite

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... this partial confirmation of the "morale theory" as an explanation for wage rigidity, half of the employers in our experiment cut wages and lose money as a result. Because our design allows us to compare beliefs and e↵ort precisely, we find that when employers don't believe the morale theory they will not hold wages rigid. In a treatment where a recession is o↵set by nominal inflation, real wage cuts do not have a significant e↵ect. Loss averse employers are less likely to cut wages and more likely to correctly predict the negative e↵ect of wage cuts. (JEL codes: C92, D84, J31)