Job-to-job transitions and wage dynamics

In this paper, I extend the theoretical framework of job-to-job transitions with stochastic idiosyncratic productivity developed in Nagypal (2006) by allowing for wages to be determined through an optimal dynamic contract between a risk-averse worker and a risk-neutral employer. The contract considered is a generalization of that studied by Burdett and Coles (2003) to an environment with stochastic productivity. I show that, just as in Burdett and Coles, the optimal contract features an upward-sloping wage profile. In addition, due to the presence of stochastic productivity, the optimal contract also features a productivity threshold below which the relationship is terminated and the worker is released into unemployment. This means that variation in productivity affects workers primarily through the implied variation in the propensity of separation into unemployment. The model features endogenous job-to-job transitions, some of which are accompanied by a wage decline, where the latter is a result of a worker's desire to quit relationships that have a high propensity to result in a separation into unemployment. Moreover, the extended model retains the desirable features of the model studied in Nagypal (2006) by being able to quantitatively match salient features of job-to-job transitions.