Revisiting the Assumption of a Small Labor Surplus

The flow profits from labor drive, to a large extent, the business cycle of job creation in the Mortensen-Pissarides model of search unemployment. In a world driven by shocks to productivity, one calibration strategy to obtain very large amplification is to assume firms make very small economic profits because the wage paid to labor is near its marginal product. This is the so-called small labor surplus assumption. This calibration, however, results in the value of creating a job being frequently, and persistently, below the the cost of a vacancy, violating a condition for firm choosing to have open job vacancies. We solve the model with a non-negativity constraint on vacancy postings and show, first, that this constraint binds frequently, leading to very different business cycle moments. Second, of concern to implementation in models of the business cycle, we show that this holds allowing for risk averse agents and a stochastic discount factor affects the results. Finally, we propose an alternative calibration strategy based on the model’s stochastic moments.